SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
☒ Quarterly Report Under Section 13 or 15(d) of the
Securities Exchange Act of 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2019MARCH 31, 2020
OR
☐ Transition Report Pursuant To Section 13 or 15(d) of the
Securities Exchange Act of 1934
COMMISSION FILE NUMBER 001-38661
Elanco Animal Health Incorporated
(Exact name of Registrant as specified in its charter)
| | | | | | | | |
| INDIANA | | 82-5497352 |
| (State or other jurisdiction of | | (I.R.S. Employer |
| incorporation or organization) | | Identification No.) |
2500 INNOVATION WAY, GREENFIELD, INDIANA 46140
(Address of principal executive offices)
Registrant’s telephone number, including area code (877) 352-6261
Securities registered pursuant to Section 12(b) of the Act:
| | | | | | | | |
| Title of each class | Trading Symbol(s) | Name of each exchange on which registered |
| Common stock, no par value | ELAN | New York Stock Exchange |
| 5.00% Tangible Equity Units | ELAT | New York Stock Exchange |
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.
Yes ý☒ No o☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Yes ý☒ No o☐
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of a “large accelerated filer,” “accelerated filer,” “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
| | | | | | | | | | | | | | | | | | | | | | | |
Large accelerated filer | ☒o | | | | | | Accelerated filer | ☐o |
Non-accelerated filer | ☐ý | | | | | | Smaller reporting company | ☐o |
| | | | | | Emerging growth company | ☐o |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o☐ No ý☒
The number of shares of common stock outstanding as of November 6, 2019May 4, 2020 were 373,004,001398,894,363
Elanco Animal Health Incorporated
Form 10-Q
For the Quarter Ended September 30, 2019March 31, 2020
Table of Contents
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| | Unaudited Condensed Consolidated and Combined Statements of Operations (Unaudited) | | |
| | Unaudited Condensed Consolidated and Combined Statements of Comprehensive Income (Loss) (Unaudited) | | |
| | Unaudited Condensed Consolidated Balance Sheets (Unaudited) | | |
| | Unaudited Condensed Consolidated and Combined Statements of Equity (Unaudited) | | |
| | Unaudited Condensed Consolidated and Combined Statements of Cash Flows (Unaudited) | | |
| | Notes to Condensed Consolidated Financial Statements (Unaudited) | | |
| | Notes to Unaudited Condensed Consolidated and Combined Financial Statements | | |
| | Management's Discussion and Analysis of Financial Condition and Results of Operations | | |
| | Overview | | |
| | Results of Operations | | |
| | Summary of Changes | | |
| | Liquidity and Capital Resources | | |
| | Contractual Obligations | | |
| Item 3. | | Quantitative and Qualitative Disclosures About Market Risk | | |
| Item 4. | | Controls and Procedures | | |
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| | Legal Proceedings | | |
| Item 1A. | | Risk Factors | | |
| 2. | | | | |
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| Item 3. | | Defaults Upon Senior Securities | | |
| Item 4. | | Mine Safety Disclosures | | |
| Item 5. | | Other Information | | |
| | Exhibits | | | | |
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Forward-Looking Statements
T
his
This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the federal securities laws. This quarterly report contains forward-looking statements, including, without limitation, statements concerning the impact on our business caused by the coronavirus global pandemic, estimated "stand up" costs, our estimated interest expense, our industry and our operations, performance and financial condition, including in particular, statements relating to our business, growth strategies, product development efforts and future expenses.
Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, by their nature, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. As a result, our actual results may differ materially from those contemplated by the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements include regional, national, or global political, economic, business, competitive, market, and regulatory conditions, including but not limited to the following:
•heightened competition, including from innovation or generics;
•the impact of disruptive innovations and advances in veterinary medical practices, animal health technologies and alternatives to animal-derived protein;
•changes in regulatory restrictions on the use of antibiotics in food animals;
•the impact on our operations, the supply chain, customer demand, and our liquidity as a result of the coronavirus (COVID-19) global health pandemic;
•our ability to implement our business strategies or achieve targeted cost efficiencies and gross margin improvements;
•consolidation of our customers and distributors;
•an outbreak of infectious disease carried by food animals;
•the success of our research and development (R&D) and licensing efforts;
•our ability to complete acquisitions and successfully integrate the businesses we acquire, including the animal health business of Bayer Aktiengesellschaft (Bayer);
•the impact of the COVID-19 global health pandemic on our ability to obtain financing forcomplete the acquisition of the Bayer animal health business on favorable terms;of Bayer and achieve the anticipated revenue, earnings, accretion and other benefits;
•misuse, off-label or counterfeiting use of our products;
•unanticipated safety, quality or efficacy concerns associated with our products;
•the impact of weather conditions and the availability of natural resources;
•disruption in our supply chain due to manufacturing issues experienced by our contract manufacturers;
•the impact of increased or decreased sales to our channel distributors resulting in higher or lower inventory levels held by them in advance of or trailing actual customer demand, which could lead to variations in quarterly revenue results;
•risks related to our presence in emerging markets;
•changes in United States (U.S.) foreign trade policy, imposition of tariffs or trade disputes;
•the impact of global macroeconomic conditions; and
•the effect on our business resulting from our separation from Eli Lilly & Co.and Company (Lilly), including the various costs associated with transition to a standalone entity, including the ability to stand alone entity.up our enterprise resource planning (ERP) system and other information technology systems.
See “Risk Factors,” of Part I of our Annual Report on Form 10-K for the year ended December 31, 20182019 filed with the Securities and Exchange Commission (SEC) and Item 1A, "Risk Factors," of Part II of this Quarterly Report on Form 10-Q, and of Part II of our Quarterly Reports on Form 10-Q for the quarterly periods ended June 30, 2019 and March 31, 2019, for a further description of these and other factors. Although we have attempted to identify important risk factors, there may be other risk factors not presently known to us or that we presently believe are not material that
could cause actual results and developments to differ materially from those made in or suggested by the forward-looking statements contained in this quarterly report. If any of these risks materialize, or if any of the above assumptions underlying forward-looking statements prove incorrect, actual results and developments may differ materially from those made in or suggested by the forward-looking statements contained in this quarterly report. For the reasons described above, we caution you against relying on any forward-looking statements, which should also be read in conjunction with the other cautionary statements that are included elsewhere in this quarterly report. Any forward-looking statement made by us in this quarterly report speaks only as of the date hereof. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to
predict all of them. We undertake no obligation to publicly update or to revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless specifically expressed as such, and should be viewed as historical data.
PART I. Financial Information
Item 1. Financial Statements
Elanco Animal Health Incorporated
Unaudited Condensed Consolidated and Combined Statements of Operations (Unaudited)
(Dollars and shares in millions, except per-share data)
| | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | Three Months Ended March 31, | |
| | | 2019 | | 2018 | | 2019 | | 2018 | | | 2020 | | 2019 |
| Revenue | Revenue | $ | 771.3 | | | $ | 761.1 | | | $ | 2,284.0 | | | $ | 2,267.5 | | Revenue | | $ | 657.7 | | | $ | 731.1 | |
| Costs, expenses and other: | Costs, expenses and other: | | Costs, expenses and other: | | |
| Cost of sales | Cost of sales | 360.4 | | | 369.8 | | | 1,060.2 | | | 1,161.3 | | Cost of sales | | 332.7 | | | 343.8 | |
| Research and development | Research and development | 69.9 | | | 58.9 | | | 202.8 | | | 185.5 | | Research and development | | 66.8 | | | 64.1 | |
| Marketing, selling and administrative | Marketing, selling and administrative | 192.3 | | | 179.0 | | | 574.3 | | | 550.1 | | Marketing, selling and administrative | | 182.0 | | | 181.1 | |
| Amortization of intangible assets | Amortization of intangible assets | 50.7 | | | 48.7 | | | 149.0 | | | 147.3 | | Amortization of intangible assets | | 51.6 | | | 49.0 | |
| Asset impairment, restructuring and other special charges (Note 7) | Asset impairment, restructuring and other special charges (Note 7) | 77.2 | | | 12.4 | | | 133.9 | | | 82.8 | | Asset impairment, restructuring and other special charges (Note 7) | | 74.8 | | | 24.9 | |
| Interest expense, net of capitalized interest | Interest expense, net of capitalized interest | 18.7 | | | 8.6 | | | 60.2 | | | 8.6 | | Interest expense, net of capitalized interest | | 16.5 | | | 20.8 | |
| Other–net, expense | Other–net, expense | 14.6 | | | 4.9 | | | 21.1 | | | 15.6 | | Other–net, expense | | 1.1 | | | 2.6 | |
| | 783.8 | | | 682.3 | | | 2,201.5 | | | 2,151.2 | | | | 725.5 | | | 686.3 | |
| Income (loss) before income taxes | Income (loss) before income taxes | (12.5) | | | 78.8 | | | 82.5 | | | 116.3 | | Income (loss) before income taxes | | (67.8) | | | 44.8 | |
| Income tax (benefit) expense | Income tax (benefit) expense | (22.5) | | | 18.6 | | | 5.1 | | | 46.2 | | Income tax (benefit) expense | | (18.7) | | | 13.3 | |
| Net income | $ | 10.0 | | | $ | 60.2 | | | $ | 77.4 | | | $ | 70.1 | | |
| Net income (loss) | | Net income (loss) | | $ | (49.1) | | | $ | 31.5 | |
| | Earnings per share: | | |
| Earnings (loss) per share: | | Earnings (loss) per share: | | |
| Basic | Basic | $ | 0.03 | | | $ | 0.20 | | | $ | 0.21 | | | $ | 0.24 | | Basic | | $ | (0.12) | | | $ | 0.09 | |
| Diluted | Diluted | $ | 0.03 | | | $ | 0.20 | | | $ | 0.21 | | | $ | 0.24 | | Diluted | | $ | (0.12) | | | $ | 0.09 | |
| Weighted average shares outstanding: | Weighted average shares outstanding: | | Weighted average shares outstanding: | | |
| Basic | Basic | 371.6 | | 301.2 | | 367.7 | | 296.0 | Basic | | 403.9 | | 365.7 |
| Diluted | Diluted | 373.2 | | 301.2 | | 368.7 | | 296.0 | Diluted | | 403.9 | | 366.0 |
|
See notes to unaudited condensed consolidated and combined financial statements.
Elanco Animal Health Incorporated
Unaudited Condensed Consolidated and Combined Statements of Comprehensive Income (Loss) (Unaudited)
Elanco Animal Health Incorporated
(Dollars in millions)
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | 2019 | | 2018 | | | 2020 | | 2019 |
| Net income | $ | 10.0 | | | $ | 60.2 | | | $ | 77.4 | | | $ | 70.1 | | |
| Net income (loss) | | Net income (loss) | | $ | (49.1) | | | $ | 31.5 | |
| Other comprehensive income (loss): | Other comprehensive income (loss): | | | Other comprehensive income (loss): | | |
| Unrealized loss on derivatives for cash flow hedges, net of taxes | | Unrealized loss on derivatives for cash flow hedges, net of taxes | | (39.2) | | | — | |
| Foreign currency translation | Foreign currency translation | (58.9) | | | 85.1 | | | (53.7) | | | (20.6) | | Foreign currency translation | | (29.3) | | | (30.2) | |
| Defined benefit pension and retiree health benefit plans, net of taxes | Defined benefit pension and retiree health benefit plans, net of taxes | 21.2 | | | 9.4 | | | 23.4 | | | 10.8 | | Defined benefit pension and retiree health benefit plans, net of taxes | | (0.4) | | | 2.0 | |
| Other comprehensive income (loss), net of tax | (37.7) | | | 94.5 | | | (30.3) | | | (9.8) | | |
| Other comprehensive loss, net of tax | | Other comprehensive loss, net of tax | | (68.9) | | | (28.2) | |
| Comprehensive income (loss) | Comprehensive income (loss) | $ | (27.7) | | | $ | 154.7 | | | $ | 47.1 | | | $ | 60.3 | | Comprehensive income (loss) | | $ | (118.0) | | | $ | 3.3 | |
See notes to unaudited condensed consolidated and combined financial statements.
Elanco Animal Health Incorporated
Condensed Consolidated Balance Sheets
(Dollars in millions)
| | | September 30, 2019 | | December 31, 2018 | | March 31, 2020 | | December 31, 2019 |
| | (Unaudited) | | | | (Unaudited) | | |
| Assets | Assets | | | Assets | | |
| Current Assets | Current Assets | | Current Assets | |
| Cash and cash equivalents | Cash and cash equivalents | $ | 309.2 | | | $ | 474.8 | | Cash and cash equivalents | $ | 1,206.4 | | | $ | 334.0 | |
| Accounts receivable, net of allowances of $6.3 (2019) and $8.4 (2018) | 758.3 | | | 651.8 | | |
| Accounts receivable, net of allowances of $7.4 (2020) and $6.2 (2019) | | Accounts receivable, net of allowances of $7.4 (2020) and $6.2 (2019) | 676.8 | | | 816.9 | |
| Other receivables | Other receivables | 65.1 | | | 57.6 | | Other receivables | 66.9 | | | 73.0 | |
| Inventories (Note 8) | Inventories (Note 8) | 1,068.7 | | | 1,004.1 | | Inventories (Note 8) | 1,019.0 | | | 1,050.7 | |
| Prepaid expenses and other | Prepaid expenses and other | 98.0 | | | 113.9 | | Prepaid expenses and other | 132.1 | | | 87.4 | |
| | Restricted cash (Note 17) | 11.1 | | | 202.7 | | |
| Receivable from Lilly (Note 16) | | Receivable from Lilly (Note 16) | 8.7 | | | — | |
| Restricted cash (Note 16) | | Restricted cash (Note 16) | 10.7 | | | 11.1 | |
| Total current assets | Total current assets | 2,310.4 | | | 2,504.9 | | Total current assets | 3,120.6 | | | 2,373.1 | |
| Noncurrent Assets | Noncurrent Assets | | | | Noncurrent Assets | | | |
| | Goodwill | Goodwill | 2,946.4 | | | 2,958.0 | | Goodwill | 3,004.0 | | | 2,989.6 | |
| Other intangibles, net | Other intangibles, net | 2,435.0 | | | 2,453.0 | | Other intangibles, net | 2,455.5 | | | 2,482.8 | |
| Other noncurrent assets | Other noncurrent assets | 220.2 | | | 118.4 | | Other noncurrent assets | 217.0 | | | 185.0 | |
| Property and equipment, net of accumulated depreciation of $909.3 (2019) and $878.6 (2018) | 911.7 | | | 922.4 | | |
| Property and equipment, net of accumulated depreciation of $919.7 (2020) and $930.5 (2019) | | Property and equipment, net of accumulated depreciation of $919.7 (2020) and $930.5 (2019) | 930.1 | | | 955.3 | |
| | Total assets | Total assets | $ | 8,823.7 | | | $ | 8,956.7 | | Total assets | $ | 9,727.2 | | | $ | 8,985.8 | |
| Liabilities and Equity | Liabilities and Equity | | | | Liabilities and Equity | | | |
| Current Liabilities | Current Liabilities | | Current Liabilities | |
| Accounts payable | Accounts payable | $ | 206.1 | | | $ | 205.2 | | Accounts payable | $ | 215.0 | | | $ | 222.6 | |
| Employee compensation | Employee compensation | 88.8 | | | 98.9 | | Employee compensation | 56.2 | | | 99.6 | |
| Sales rebates and discounts | Sales rebates and discounts | 182.2 | | | 169.9 | | Sales rebates and discounts | 192.7 | | | 211.0 | |
| Current portion of long-term debt (Note 9) | 24.5 | | | 29.0 | | |
| Current portion of long-term debt (Note 10) | | Current portion of long-term debt (Note 10) | 26.0 | | | 24.5 | |
| | Other current liabilities | Other current liabilities | 181.5 | | | 199.0 | | Other current liabilities | 217.6 | | | 244.4 | |
| Payable to Lilly (Note 17) | 58.4 | | | 268.7 | | |
| Payable to Lilly (Note 16) | | Payable to Lilly (Note 16) | — | | | 16.4 | |
| Total current liabilities | Total current liabilities | 741.5 | | | 970.7 | | Total current liabilities | 707.5 | | | 818.5 | |
| Noncurrent Liabilities | Noncurrent Liabilities | | | | Noncurrent Liabilities | | | |
| Long-term debt (Note 9) | 2,335.6 | | | 2,443.3 | | |
| Accrued retirement benefits (Note 15) | 81.4 | | | 109.1 | | |
| Deferred taxes (Note 12) | 81.1 | | | 114.6 | | |
| Long-term debt (Note 10) | | Long-term debt (Note 10) | 2,035.6 | | | 2,330.5 | |
| Accrued retirement benefits | | Accrued retirement benefits | 82.1 | | | 82.5 | |
| Deferred taxes | | Deferred taxes | 90.2 | | | 100.8 | |
| Other noncurrent liabilities | Other noncurrent liabilities | 96.4 | | | 121.5 | | Other noncurrent liabilities | 150.3 | | | 106.6 | |
| Total liabilities | Total liabilities | 3,336.0 | | | 3,759.2 | | Total liabilities | 3,065.7 | | | 3,438.9 | |
| Commitments and Contingencies (Note 13) | Commitments and Contingencies (Note 13) | — | | | — | | Commitments and Contingencies (Note 13) | — | | | — | |
| Equity | Equity | | Equity | |
| | Common stock, no par value, 5,000,000,000 shares authorized, 372,999,206 and 365,643,911 shares issued and outstanding as of September 30, 2019 and December 31, 2018, respectively | — | | | — | | |
| Preferred stock, no par value, 1,000,000,000 shares authorized; 0ne issued | | Preferred stock, no par value, 1,000,000,000 shares authorized; 0ne issued | — | | | — | |
| Common stock, no par value, 5,000,000,000 shares authorized, 398,825,969 and 373,011,513 shares issued and outstanding as of March 31, 2020 and December 31, 2019, respectively | | Common stock, no par value, 5,000,000,000 shares authorized, 398,825,969 and 373,011,513 shares issued and outstanding as of March 31, 2020 and December 31, 2019, respectively | — | | | — | |
| Additional paid-in capital | Additional paid-in capital | 5,646.4 | | | 5,403.3 | | Additional paid-in capital | 6,870.3 | | | 5,636.3 | |
| Retained earnings | Retained earnings | 93.8 | | | | 16.4 | | Retained earnings | 33.8 | | | 84.3 | |
| Accumulated other comprehensive loss | Accumulated other comprehensive loss | (252.5) | | | (222.2) | | Accumulated other comprehensive loss | (242.6) | | | (173.7) | |
| Total equity | Total equity | 5,487.7 | | | 5,197.5 | | Total equity | 6,661.5 | | | 5,546.9 | |
| Total liabilities and equity | Total liabilities and equity | $ | 8,823.7 | | | $ | 8,956.7 | | Total liabilities and equity | $ | 9,727.2 | | | $ | 8,985.8 | |
See notes to unaudited condensed consolidated and combined financial statements.
Elanco Animal Health Incorporated
Unaudited Condensed Consolidated and Combined Statements of Equity (Unaudited)
(Dollars and shares in millions)
| | | Common Stock | | | Accumulated Other Comprehensive Income (Loss) | | | | Common Stock | | | | | Accumulated Other Comprehensive Income (Loss) | | |
| | Shares | | Amount | | Additional Paid-in Capital | | Net Parent Company Investment | | Retained Earnings | | Foreign Currency Translation | | Defined Benefit Pension and Retiree Health Benefit Plans | | Total | | Total Equity | | Shares | | Amount | | Additional Paid-in Capital | | | Retained Earnings | | Cash Flow Hedge Gain (Loss) | | Foreign Currency Translation | | Defined Benefit Pension and Retiree Health Benefit Plans | | Total | | Total Equity |
| December 31, 2018 | December 31, 2018 | 365.6 | | | $ | — | | | $ | 5,403.3 | | | $ | — | | | $ | 16.4 | | | $ | (218.2) | | | $ | (4.0) | | | $ | (222.2) | | | $ | 5,197.5 | | December 31, 2018 | 365.6 | | | $ | — | | | $ | 5,403.3 | | | | $ | 16.4 | | | $ | — | | | $ | (218.2) | | | $ | (4.0) | | | $ | (222.2) | | | $ | 5,197.5 | |
| | Net income | Net income | — | | | — | | | — | | | — | | | 31.5 | | | — | | | — | | | — | | | 31.5 | | Net income | — | | | — | | | — | | | | 31.5 | | | — | | | — | | | — | | | — | | | 31.5 | |
| Other comprehensive income (loss), net of tax | Other comprehensive income (loss), net of tax | — | | | — | | | — | | | — | | | — | | | (30.2) | | | 2.0 | | | (28.2) | | | (28.2) | | Other comprehensive income (loss), net of tax | — | | | — | | | — | | | | — | | | — | | | (30.2) | | | 2.0 | | | (28.2) | | | (28.2) | |
Separation activities(1) | Separation activities(1) | — | | | — | | | (7.0) | | | — | | | — | | | — | | | — | | | — | | | (7.0) | | Separation activities(1) | — | | | — | | | (7.0) | | | | — | | | — | | | — | | | — | | | — | | | (7.0) | |
| Stock compensation | Stock compensation | — | | | — | | | 2.4 | | | — | | | — | | | — | | | — | | | — | | | 2.4 | | Stock compensation | — | | | — | | | 2.4 | | | | — | | | — | | | — | | | — | | | — | | | 2.4 | |
| Issuance of stock under employee stock plans, net | Issuance of stock under employee stock plans, net | 0.1 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | Issuance of stock under employee stock plans, net | 0.1 | | | | — | | | — | | | | — | | | | — | | | — | | | | — | | | — | | | — | |
| | March 31, 2019 | March 31, 2019 | 365.7 | | | | $ | — | | | | $ | 5,398.7 | | | | $ | — | | | | $ | 47.9 | | | | $ | (248.4) | | | | $ | (2.0) | | | | $ | (250.4) | | | | $ | 5,196.2 | | March 31, 2019 | 365.7 | | | $ | — | | | $ | 5,398.7 | | | | $ | 47.9 | | | $ | — | | | $ | (248.4) | | | $ | (2.0) | | | $ | (250.4) | | | $ | 5,196.2 | |
| Net income | — | | | — | | | | — | | | | — | | | | 35.9 | | | | — | | | | — | | | | — | | | | 35.9 | | |
| Other comprehensive income, net of tax | — | | | — | | | | — | | | | — | | | | — | | | | 35.4 | | | | 0.2 | | | | 35.6 | | | | 35.6 | | |
Separation activities(1) | — | | | — | | | | (18.4) | | | | — | | | | — | | | | — | | | | — | | | | — | | | | (18.4) | | |
| Stock compensation | — | | | — | | | | 14.3 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 14.3 | | |
| | Other | — | | | — | | | | 1.9 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 1.9 | | |
| | June 30, 2019 | 365.7 | | | $ | — | | | | $ | 5,396.5 | | | | $ | — | | | | $ | 83.8 | | | | $ | (213.0) | | | | $ | (1.8) | | | | $ | (214.8) | | | | $ | 5,265.5 | | |
| Net income | — | | | — | | | | — | | | | — | | | | 10.0 | | | | — | | | | — | | | | — | | | | 10.0 | | |
| Other comprehensive income (loss), net of tax | — | | | — | | | | — | | | | — | | | | — | | | | (58.9) | | | | 21.2 | | | | (37.7) | | | | (37.7) | | |
Separation activities(1) | — | | | — | | | | (3.0) | | | | — | | | | — | | | | — | | | | — | | | | — | | | | (3.0) | | |
| Stock compensation | — | | | — | | | | 11.3 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 11.3 | | |
| Issuances of stock in connection with Aratana acquisition:(2) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Issuance to Aratana shareholders for acquisition | 7.2 | | | — | | | | 238.0 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 238.0 | | |
| Accelerated vesting of equity awards | 0.1 | | | — | | | | 3.6 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 3.6 | | |
| | September 30, 2019 | 373.0 | | | $ | — | | | | $ | 5,646.4 | | | | $ | — | | | | $ | 93.8 | | | | $ | (271.9) | | | | $ | 19.4 | | | | $ | (252.5) | | | | $ | 5,487.7 | | |
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| December 31, 2019 | 373.0 | | | $ | — | | | $ | 5,636.3 | | | | | $ | 84.3 | | | $ | — | | | $ | (198.4) | | | $ | 24.7 | | | $ | (173.7) | | | $ | 5,546.9 | |
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| Net loss | — | | | — | | | — | | | | | (49.1) | | | — | | | — | | | — | | | — | | | (49.1) | |
Adoption of Accounting Standards Update 2016-13(2) | — | | | — | | | — | | | | | (1.4) | | | — | | | — | | | — | | | — | | | (1.4) | |
| Other comprehensive loss, net of tax | — | | | — | | | — | | | | | — | | | (39.2) | | | (29.3) | | | (0.4) | | | (68.9) | | | (68.9) | |
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Separation activities(1) | — | | | — | | | 15.8 | | | | | — | | | — | | | — | | | — | | | — | | | 15.8 | |
| Stock compensation | — | | | — | | | 11.1 | | | | | — | | | — | | | — | | | — | | | — | | | 11.1 | |
| Issuance of stock under employee stock plans, net | 0.8 | | | — | | | (12.8) | | | | | — | | | — | | | — | | | — | | | — | | | (12.8) | |
Issuance of common stock, net of issuance costs(3) | 25.0 | | | — | | | 767.5 | | | | | — | | | — | | | — | | | — | | | — | | | 767.5 | |
Issuance of tangible equity units, net of issuance costs(3) | — | | | — | | | 452.4 | | | | | — | | | — | | | — | | | — | | | — | | | 452.4 | |
| March 31, 2020 | 398.8 | | | $ | — | | | $ | 6,870.3 | | | | | $ | 33.8 | | | $ | (39.2) | | | $ | (227.7) | | | $ | 24.3 | | | $ | (242.6) | | | $ | 6,661.5 | |
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(1) See Note 17:16: Related Party Agreements and Transactions for further discussion.
(2) See Note 6: Acquisitions4: Implementation of New Financial Accounting Pronouncements for further discussion.
(3) See Note 9: Equity for further discussion.
See notes to unaudited condensed consolidated and combined financial statements.
Elanco Animal Health Incorporated
Unaudited Condensed Consolidated and Combined Statements of Equity, continued
(Dollars and shares in millions)
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| Common Stock | | | | | | | | | | Accumulated Other Comprehensive Income (Loss) | | | | | | |
| Shares | | Amount | | Additional Paid-in Capital | | Net Parent Company Investment | | Retained Earnings | | Foreign Currency Translation | | Defined Benefit Pension and Retiree Health Benefit Plans | | Total | | Total Equity |
| December 31, 2017 | 293.3 | | | $ | — | | | $ | — | | | $ | 8,036.9 | | | $ | — | | | $ | (227.2) | | | $ | (29.4) | | | $ | (256.6) | | | $ | 7,780.3 | |
| Adoption of Accounting Standards Update 2016-16 | — | | | — | | | — | | | (0.3) | | | — | | | — | | | — | | | — | | | (0.3) | |
| Net income | — | | | — | | | — | | | 72.7 | | | — | | | — | | | — | | | — | | | 72.7 | |
| Other comprehensive income (loss), net of tax | — | | | — | | | — | | | — | | | — | | | 119.2 | | | (0.6) | | | 118.6 | | | 118.6 | |
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Transfers (to)/from Lilly, net(1) | — | | | — | | | — | | | (69.2) | | | — | | | — | | | — | | | — | | | (69.2) | |
| March 31, 2018 | 293.3 | | | | $ | — | | | | $ | — | | | | $ | 8,040.1 | | | | $ | — | | | | $ | (108.0) | | | | $ | (30.0) | | | | $ | (138.0) | | | | $ | 7,902.1 | |
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| Net income (loss) | — | | | — | | | — | | | (62.8) | | | — | | | — | | | — | | | — | | | (62.8) | |
| Other comprehensive income (loss), net of tax | — | | | — | | | — | | | — | | | — | | | (224.9) | | | 2.0 | | | (222.9) | | | (222.9) | |
| Dividends declared | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | |
Transfers (to)/from Lilly, net(1) | — | | | | — | | | | — | | | | (40.3) | | | | | | | | — | | | | — | | | | — | | | | (40.3) | |
| June 30, 2018 | 293.3 | | | $ | — | | | | $ | — | | | | $ | 7,937.0 | | | | $ | — | | | | $ | (332.9) | | | | $ | (28.0) | | | | $ | (360.9) | | | | $ | 7,576.1 | |
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| Net income | — | | | — | | | | — | | | | 60.2 | | | | — | | | | — | | | | — | | | | — | | | | 60.2 | |
| Other comprehensive income, net of tax | — | | | — | | | | — | | | | — | | | | — | | | | 85.1 | | | | 9.4 | | | | 94.5 | | | | 94.5 | |
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Transfers (to)/from Lilly, net(1) | — | | | — | | | | — | | | | (116.8) | | | | — | | | | — | | | | — | | | | — | | | | (116.8) | |
Separation activities(1) | — | | | — | | | | — | | | | 2.2 | | | | — | | | | 56.1 | | | | — | | | | 56.1 | | | | 58.3 | |
| Issuance of common stock | 72.3 | | | — | | | | 1,659.7 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 1,659.7 | |
| Consideration to Lilly in connection with the Separation | — | | | — | | | | (4,194.9) | | | | — | | | | — | | | | — | | | | — | | | | — | | | | (4,194.9) | |
| Reclassification of net parent company investment | — | | | — | | | | 7,882.6 | | | | (7,882.6) | | | | — | | | | — | | | | — | | | | — | | | | — | |
| September 30, 2018 | 365.6 | | | $ | — | | | | $ | 5,347.4 | | | | $ | — | | | | $ | — | | | | $ | (191.7) | | | | $ | (18.6) | | | | $ | (210.3) | | | | $ | 5,137.1 | |
(1) See Note 17: Related Party Agreements and Transactions for further discussion.
Elanco Animal Health Incorporated
Unaudited Condensed Consolidated and Combined Statements of Cash Flows (Unaudited)
(Dollars in millions)
| | | Nine Months Ended September 30, | | | Three Months Ended March 31, | |
| | | 2019 | | 2018 | | 2020 | | 2019 |
| Cash Flows from Operating Activities | Cash Flows from Operating Activities | | | Cash Flows from Operating Activities | | |
| Net income | $ | 77.4 | | | $ | 70.1 | | |
| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: | | |
| Net income (loss) | | Net income (loss) | $ | (49.1) | | | $ | 31.5 | |
| Adjustments to reconcile net income (loss) to cash flows from operating activities: | | Adjustments to reconcile net income (loss) to cash flows from operating activities: | |
| Depreciation and amortization | Depreciation and amortization | 231.1 | | | 222.3 | | Depreciation and amortization | 81.5 | | | 75.2 | |
| Change in deferred income taxes | Change in deferred income taxes | 14.9 | | | 12.6 | | Change in deferred income taxes | (25.1) | | | 16.3 | |
| Stock-based compensation expense | Stock-based compensation expense | 36.7 | | | 20.2 | | Stock-based compensation expense | 11.1 | | | 7.7 | |
| Asset impairment charges | Asset impairment charges | 24.7 | | | 102.5 | | Asset impairment charges | — | | | 4.0 | |
| Gain on sale of assets | | Gain on sale of assets | (3.8) | | | — | |
| | Changes in operating assets and liabilities | Changes in operating assets and liabilities | (267.0) | | | (83.4) | | Changes in operating assets and liabilities | (9.8) | | | (117.2) | |
| | Other non-cash operating activities, net | Other non-cash operating activities, net | (20.0) | | | 3.5 | | Other non-cash operating activities, net | (0.5) | | | (9.4) | |
| Net Cash Provided by Operating Activities | 97.8 | | | 347.8 | | |
| Net Cash Provided by (Used for) Operating Activities | | Net Cash Provided by (Used for) Operating Activities | 4.3 | | | 8.1 | |
| Cash Flows from Investing Activities | Cash Flows from Investing Activities | | Cash Flows from Investing Activities | |
| Net purchases of property and equipment | Net purchases of property and equipment | (86.0) | | | (74.3) | | Net purchases of property and equipment | (12.6) | | | (28.0) | |
| Cash paid for acquisitions, net of cash acquired | (32.8) | | | — | | |
| | Proceeds from settlement of net investment hedges (Note 11) | | Proceeds from settlement of net investment hedges (Note 11) | 25.2 | | | — | |
| | Purchases of software | | Purchases of software | (31.8) | | | (2.5) | |
| Other investing activities, net | Other investing activities, net | (41.7) | | | (4.6) | | Other investing activities, net | (0.4) | | | (0.5) | |
| Net Cash Used for Investing Activities | Net Cash Used for Investing Activities | (160.5) | | | (78.9) | | Net Cash Used for Investing Activities | (19.6) | | | (31.0) | |
| Cash Flows from Financing Activities | Cash Flows from Financing Activities | | Cash Flows from Financing Activities | |
| Repayments of borrowings (Note 9) | (115.0) | | | — | | |
| Proceeds from issuance of long-term debt (Note 9) | — | | | 2,477.7 | | |
| Repayments of borrowings (Note 10) | | Repayments of borrowings (Note 10) | (371.4) | | | (7.5) | |
| Proceeds from issuance of long-term debt (Note 10) | | Proceeds from issuance of long-term debt (Note 10) | 79.2 | | | — | |
| | Proceeds from issuance of common stock (Note 1) | — | | | 1,659.7 | | |
| | Proceeds from issuance of common stock and tangible equity units (Note 9) | | Proceeds from issuance of common stock and tangible equity units (Note 9) | 1,219.9 | | | — | |
| Debt issuance costs | | Debt issuance costs | (3.1) | | | — | |
| | Consideration paid to Lilly in connection with the Separation (Note 1) | Consideration paid to Lilly in connection with the Separation (Note 1) | (191.6) | | | (3,559.1) | | Consideration paid to Lilly in connection with the Separation (Note 1) | — | | | (175.1) | |
| | Other net financing transactions with Lilly | Other net financing transactions with Lilly | 6.3 | | | (247.4) | | Other net financing transactions with Lilly | (15.2) | | | (156.4) | |
| Other financing activities, net | Other financing activities, net | 1.7 | | | (3.7) | | Other financing activities, net | (12.8) | | | (0.5) | |
| Net Cash Provided by (Used for) Financing Activities | Net Cash Provided by (Used for) Financing Activities | (298.6) | | | 327.2 | | Net Cash Provided by (Used for) Financing Activities | 896.6 | | | (339.5) | |
| Effect of exchange rate changes on cash and cash equivalents | Effect of exchange rate changes on cash and cash equivalents | 4.1 | | | 15.4 | | Effect of exchange rate changes on cash and cash equivalents | (9.3) | | | (14.5) | |
| Net increase (decrease) in cash, cash equivalents and restricted cash | Net increase (decrease) in cash, cash equivalents and restricted cash | (357.2) | | | 611.5 | | Net increase (decrease) in cash, cash equivalents and restricted cash | 872.0 | | | (376.9) | |
| Cash, cash equivalents and restricted cash at January 1 | Cash, cash equivalents and restricted cash at January 1 | 677.5 | | | 323.4 | | Cash, cash equivalents and restricted cash at January 1 | 345.1 | | | 677.5 | |
| Cash, cash equivalents and restricted cash at September 30, 2019 | $ | 320.3 | | | $ | 934.9 | | |
| Cash, cash equivalents and restricted cash at March 31 | | Cash, cash equivalents and restricted cash at March 31 | $ | 1,217.1 | | | $ | 300.6 | |
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| 2019 | | 2018 |
| Cash and cash equivalents | $ | 309.2 | | | $ | 300.0 | |
| Restricted cash (Note 17) | 11.1 | | | 634.9 | |
| Cash, cash equivalents and restricted cash at September 30, 2019 | $ | 320.3 | | | $ | 934.9 | |
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| 2020 | | 2019 |
| Cash and cash equivalents | $ | 1,206.4 | | | $ | 272.1 | |
| Restricted cash (Note 16) | 10.7 | | | 28.5 | |
| Cash, cash equivalents and restricted cash at March 31 | $ | 1,217.1 | | | $ | 300.6 | |
See notes to unaudited condensed consolidated and combined financial statements.
Elanco Animal Health Incorporated
Notes to Unaudited Condensed Consolidated and Combined Financial Statements (Unaudited)
(Tables present dollars in millions, except per-share data)
Note 1. Nature of Business and Organization
Nature of Business
Elanco Animal Health Incorporated (Elanco Parent) and its subsidiaries (collectively, Elanco, the Company, we, us or our) was formed as a wholly-owned subsidiary of Eli Lilly and Company (Lilly). Elanco is a global animal health company that innovates, develops, manufactures and markets products for companion and food animals. We offer a diverse portfolio of more than 125 brands to veterinarians and food animal producers in more than 90 countries.
Organization
Elanco Parent was formed in May 2018, as a wholly-owned subsidiary of Lilly, to serve as the ultimate parent company of substantially all of the animal health businesses of Lilly.
On September 24, 2018, Elanco Parent completed an initial public offering (IPO) resulting in the issuance of 72.3 million shares of its common stock (including shares issued pursuant to the underwriters’ option to purchase additional shares), which represented 19.8% of the outstanding shares, at $24 per share (IPO) resulting in total net proceeds, after underwriting discounts and commissions, of $1.7 billion. In connection with the completion of the IPO, through a series of equity and other transactions, Lilly transferred to Elanco Parent the animal health businesses that form its business going forward.business. In exchange, Elanco Parent has paid to Lilly approximately $4.2 billion, which includesincluded the net proceeds from the IPO, the net proceeds from the debt offering completed by Elanco Parent in August 2018 and the term loan facility entered into by Elanco Parent in September 2018 (see Note 9:10: Debt). These transactions are collectively referred to herein as the Separation.
On February 8, 2019, Lilly announced an exchange offer whereby Lilly shareholders could exchange all or a portion of Lilly common stock for shares of Elanco common stock owned by Lilly. The disposition of Elanco shares was completed on March 11, 2019, and resulted in the full separation of Elanco andalong with the disposal of Lilly's entire ownership and voting interest in Elanco.
Note 2. Basis of Presentation and Summary of Significant Accounting Policies
We have prepared the accompanying unaudited condensed consolidated and combined financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a 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. The accounts of all wholly owned and controlled subsidiaries are included in the condensed consolidated financial statements and all intercompany balances and transactions have been eliminated.
Certain reclassifications have been made to prior periods in the unaudited condensed consolidated and combined financial statements and accompanying notes to conform with the current presentation.
The information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated and combined financial statements and accompanying notes for the year ended December 31, 20182019 included in our Annual Report on Form 10-K filed with the SECSecurities and Exchange Commission (SEC) on February 20, 2019.28, 2020.
For the periods after Separation, the financial statements are prepared on a consolidated basis
Our income taxes in 2019 and thereafter reflect the results of operations, comprehensive income, financial position, equity and cash flows resulting from our operations as an independent company. For periods prior to the Separation, our financial statements are combined, have been prepared on a standalonestand-alone basis and are derived from Lilly's consolidated financial statements and accounting records. The consolidated and combined financial statements reflect the financial position, resultsindependent of operations and cash flows related to the animal health businesses that were transferred to Elanco Parent and are prepared in conformity with GAAP.
The combined financial statements include the attribution of certain assets and liabilities that historically have been held at the Lilly, corporate level but which are specifically identifiable or attributable to the businesses that have been transferred to Elanco Parent. All intercompany transactions and accounts within Elanco have been eliminated. All transactions between us and Lilly are considered to be effectively settled in the combined financial statements at
the time the intercompany transaction is recorded. The total net effect of the settlement of these intercompany transactions is reflected in the combined statements of cash flows as a financing activity and in the condensed consolidated and combined statement of equity as net parent company investment.
Prior to Separation, these combined financial statements include an allocation of expenses related to certain Lilly corporate functions, including executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations, prior to IPO. These expenses have been allocated to us based on direct usage or benefit where specifically identifiable, with the remainder allocated primarily on a pro rata basis of revenue, headcount and other measures. We consider the expenses methodology and results to be reasonable for all periods presented. However, the allocations may not be indicative of the actual expense that would have been incurred had we operated as an independent, publicly traded companyexcept for the periods presented. It is impractical to estimate what the standalone costs of Elanco would have beenperiod during which we were included in the historical periods. After the Separation, a Transitional Services Agreement (TSA) betweencombined tax return with Lilly and Elanco went into effect. Under the terms of the TSA, we will be able to use these Lilly services for a fixed term established on a service-by-service basis. We are paying Lilly mutually agreed upon fees for the Lilly services provided under the TSA. Our consolidated and combined financial statements reflect the charges for Lilly services after the IPO. See Note 17: Related Party Agreements and Transactions for additional details.
until full separation. The income tax amounts in the combined financial statements have been calculated based on a separate return methodology and presented as if our operations were separate taxpayers in the respective jurisdictions. We file income tax returns in the U.S. federal jurisdiction and various state, local and non-U.S. jurisdictions. Prior
The significant accounting policies set forth in Note 4 to full separation, certainthe consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2019 appropriately represent, in all material respects, the current status of these income tax returns were filed on a consolidated or combined basis with Eli Lilly and Company and/or its subsidiaries.
Priorour accounting policies, except as it relates to Separation, Lilly maintained various benefit and combined stock-based compensation plans at a corporate level and other benefit plans at a country level. Our employees participated in such programs and the portionadoption of the coststandards that were effective January 1, 2020 as described in Note 4: Implementation of those plans related to our employees is included in our financial statements. However, the condensed balance sheets do not include any equity issued related to stock-based compensation plans or any net benefit plan obligations unless the benefit plan covers only our dedicated employees or where the legal obligation associated with the benefit plan transferred to Elanco. Upon Lilly's full divestiture of Elanco in March 2019, all Lilly share-based awards heldNew Financial Accounting Pronouncements, and are incorporated herein by our employees were converted into awards that will be settled in Elanco shares.
Prior to Separation, the equity balance in the combined financial statements represents the excess of total assets over liabilities, including intercompany balances between Elanco and Lilly (net parent company investment) and accumulated other comprehensive income/(loss). Net parent company investment is primarily impacted by contributions from Lilly which are the result of treasury activities and net funding provided by or distributed to Lilly. See Note 17: Related Party Agreements and Transactions for further information.reference.
Note 3. Impact of Separation
In connection with the Separation, we issued $2.0 billion aggregate principal amount of senior notes in a private placement, and we also entered into a $750.0 million senior unsecured revolving credit facility and $500.0 million senior unsecured term credit facility. In connection with the Separation, we entered into various agreements with Lilly, including a master separation agreement, a tax matters agreement and the TSA.transitional services agreement (TSA).
We will also continue
In addition to have certain ongoing relationshipsthe agreements referenced above, we entered into several other related party transactions with Lilly before and at the time of the Separation. For additional information regarding our ongoing agreements, as described inwell as certain activities while Lilly was a related party, see Note 17:16: Related Party Agreements and Transactions.
Note 4. Implementation of New Financial Accounting Pronouncements
The following table provides a brief description of an accounting standardstandards that waswere effective January 1, 20192020 and waswere adopted on that date:
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Accounting Standards Update 2016-02, Leases
| | This standard was issued to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities, including leases classified as operating leases under previous GAAP, on the balance sheet and requiring additional disclosures about leasing arrangements. | | We adopted the standard on January 1, 2019 using the modified retrospective approach, applied at the beginning of the period of adoption, and we elected the package of transition practical expedients. Upon adoption of the standard, we recorded $84.9 million of right-of-use assets and $85.3 million of operating lease liabilities on our consolidated balance sheet. Adoption of this standard did not have a material impact on our consolidated statement of operations for the nine months ended September 30, 2019. See Note 11: Leases for further information. |
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The following table provides a brief description of the accounting standards applicable to us that have not yet been adopted:
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Standard | | Description | | Effective Date | | Effect on the financial statements or other significant matters | |
Accounting Standards Update 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | | This standard modifies the impairment model by requiring entities to use a forward-looking approach based on expected losses to estimate credit losses on certain types of financial instruments, including trade receivables. This may result in | | We adopted the earlierstandard using the modified retrospective approach. The impact of adoption included the first-time recognition of allowances for losses. | | This standard is effective January 1, 2020, with early adoption permitted. We intend to adopt this standardexpected credit losses (i.e., bad debt expense) on current receivables that date. | | While we are continuing to evaluate the effectnot past due, which resulted in a decrease in retained earnings of $1.4 million. Recognition of this standard, we currently doallowance and other impacts of adoption were not anticipate that this standard will have a material impact on our condensedto the consolidated financial statements. | |
Accounting Standards Update 2018-15, Intangibles - Goodwill and Other Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract | | This guidance aligns the requirements for capitalizing implementation costs incurred in a cloud-based hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. | | We implemented the guidance on a prospective basis. The adoption did not have a significant impact on the consolidated financial statements. |
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The following table provides a brief description of accounting standards applicable to us that have not yet been adopted:
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Accounting Standards Update 2019-12, Simplifying the Accounting for Income Taxes | | The amendments in this update simplify the accounting for income taxes by removing certain exceptions and clarifying certain requirements regarding franchise taxes, goodwill, consolidated tax expenses, and annual effective tax rate calculations.
| | This standard is effective January 1, 2020,2021, with early adoption permitted. We intend to adopt this standard on that date. | | We are currently evaluating the effect of this standard on our condensed consolidated financial statements. |
Accounting Standards Update 2020-04, Reference rate reform (Topic 848) - Facilitation of the Effects of Reference Rate Reform on Financial Reporting | | This update provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. | | This standard can be applied immediately, but early adoption is only available through December 31, 2022. | | We are currently in the process of evaluating the impact of the London Interbank Offered Rate (LIBOR) on our existing contracts, but do not expect that this update will have a material impact on our consolidated financial statements. |
Note 5. Revenue
Product Sales
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 obligation, which generally is at the time we ship the product to the customer. Payment terms differ by jurisdiction and customer, but payment terms in most of our major jurisdictions typically range from 30 to 120 days from date of shipment. Revenue for our product sales has not been adjusted for the effects of a financing component as we expect, at contract inception, that the period between when we transfer control of the product and when we receive payment will be one year or less. Any exceptions are either not material or we collect interest for payments made after the due date. Provisions for rebates and discounts, and returns are established in the same period the related sales are recognized. We generally ship product shortly after orders are received; therefore, we generally only have a few days of orders received but not yet shipped at the end of any reporting period. Shipping and handling activities are considered to be fulfillment activities and are not considered to be a separate performance obligation. We exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are imposed on our sales of product and collected from a customer.
Significant judgments must be made in determining the transaction price for sales of products related to anticipated rebates and discounts, and returns. The following describe the most significant of these judgments:
Sales Rebates and Discounts - Background and Uncertainties
•Most of our products are sold to wholesale distributors. We initially invoice our customers contractual list prices. Contracts with direct and indirect customers may provide for various rebates and discounts that may differ in each contract. As a consequence, to determine the appropriate transaction price for our product sales at the time we recognize a sale to a direct customer, we must estimate any rebates or discounts that ultimately will be due to the direct customer and other customers in the distribution chain under the terms of our contracts. Judgments are required in making these estimates.
•The rebate and discount amounts are recorded as a deduction to arrive at our net product sales. We estimate these accruals using an expected value approach.
•In determining the appropriate accrual amount, we consider our historical experience with similar incentives programs and current sales data to estimate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary. Although we accrue a liability for rebates related to these programs at the time the sale is recorded, the rebate related to that sale is typically paid up to six months after the rebate or incentive period expires. Because of this time lag, in any particular period rebate adjustments may incorporate revisions of accruals for several periods.
Our sales rebates and discounts are based on specific agreements and the majority relate to sales in the U.S. As of September 30,March 31, 2020 and 2019, and 2018, the liability for sales rebates and discounts in the U.S. represents approximately 71% and 70%72%, respectively, of our total liability with the next largest country representing approximately 6%8% and 8%, respectively, of our total liability.
The following table summarizes the activity in the sales rebates and discounts liability in the U.S.:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | 2019 | | 2018 | | | 2020 | | 2019 |
| Beginning balance | Beginning balance | $ | 132.1 | | | $ | 99.1 | | | $ | 118.5 | | | $ | 114.8 | | Beginning balance | | $ | 150.4 | | | $ | 118.5 | |
| Reduction of revenue | Reduction of revenue | 75.9 | | | 53.5 | | | 222.2 | | | 154.2 | | Reduction of revenue | | 60.5 | | | 65.7 | |
| Payments | Payments | (78.9) | | | (49.1) | | | (211.6) | | | (165.5) | | Payments | | (73.3) | | | (64.2) | |
| Ending balance | Ending balance | $ | 129.1 | | | $ | 103.5 | | | $ | 129.1 | | | $ | 103.5 | | Ending balance | | $ | 137.6 | | | $ | 120.0 | |
Adjustments to revenue recognized as a result of changes in estimates for the judgments described above during the three and nine months ended September 30,March 31, 2020 and 2019 and 2018 for product shipped in previous periods were not material.
Sales Returns - Background
Actual product returns were approximately 1.6% and Uncertainties0.3% of net revenue for the three months ended March 31, 2020 and 2019, respectively.
•We estimate a reserve for future product returns related to product sales using an expected value approach. This estimate is based on several factors, including: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; and estimate of the amount of time between shipment and return. Adjustments to the returns reserve have been and may in the future be required based on revised estimates to our assumptions, which would have an impact on our consolidated results of operations. We record the return amounts as a deduction to arrive at our net product sales.
Actual product returns were less than 0.1% and approximately 0.1% of net revenue for the three and nine months ended September 30, 2019 and 0.2% and 0.3% for the three and nine months endedSeptember 30, 2018, respectively, and have not fluctuated significantly as a percentage of revenue.
Disaggregation of Revenue
The following table summarizes our revenue disaggregated by product category:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | 2019 | | 2018 | | | 2020 | | 2019 |
| Companion Animal Disease Prevention | Companion Animal Disease Prevention | $ | 207.6 | | | $ | 188.6 | | | $ | 616.9 | | | $ | 603.9 | | Companion Animal Disease Prevention | | $ | 140.3 | | | $ | 185.9 | |
| Companion Animal Therapeutics | Companion Animal Therapeutics | 87.6 | | | 80.5 | | | 252.4 | | | 211.1 | | Companion Animal Therapeutics | | 65.8 | | | 81.4 | |
| Food Animal Future Protein & Health | Food Animal Future Protein & Health | 191.5 | | | 162.8 | | | 534.5 | | | 502.1 | | Food Animal Future Protein & Health | | 180.0 | | | 167.2 | |
| Food Animal Ruminants & Swine | Food Animal Ruminants & Swine | 266.2 | | | 301.5 | | | 811.8 | | | 881.1 | | Food Animal Ruminants & Swine | | 252.6 | | | 274.1 | |
Strategic Exits(1) | Strategic Exits(1) | 18.4 | | | 27.7 | | | 68.4 | | | 69.3 | | Strategic Exits(1) | | 19.0 | | | 22.5 | |
| Revenue | Revenue | $ | 771.3 | | | $ | 761.1 | | | $ | 2,284.0 | | | $ | 2,267.5 | | Revenue | | $ | 657.7 | | | $ | 731.1 | |
(1)Represents revenue from business activities we have either exited or made a strategic decision to exit.
Note 6. Acquisitions and Divestitures
2019 Acquisitions
During the three months ended September 30, 2019, we completed the acquisitions of all outstanding shares of Aratana Therapeutics, Inc. (Aratana) and Prevtec Microbia Inc. (Prevtec). These transactions were accounted for as business combinations under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our condensed consolidated financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of these acquisitions are included in our condensed consolidated financial statements from the dates of acquisition.
Aratana Therapeutics, Inc.
On July 18, 2019, we acquired Aratana, a pet therapeutics company focused on innovative therapies for dogs and cats, in afor stock transaction.and cash-based contingent value rights. Aratana is the creator of the canine osteoarthritis medicine, GalliprantGalliprant™®, the rights to which we acquired in 2016. The acquisition enhances our presence in the areas of appetite stimulants in dogs, pain relief in dogs and cats, and treatments of other conditions in the U.S. and internationally. In connection with the acquisition, we issued approximately 7.2 million shares with a value of $238.0 million to Aratana shareholders, based on our stock price on the last trading day immediately prior to the closing date. The purchase consideration also included up to $12 million in contingent value rights, which represent the rights of Aratana shareholders to receive a contingent payment of $0.25 per share in cash upon the achievement of a specified milestone as outlined in the merger agreement. We calculated an immaterial fair value for the contingent value rights using the Monte Carlo simulation model.
Contingent consideration liabilities that we previously recorded for future royalty and milestone payments in relation to the 2016 acquisition of rights to Galliprant were settled upon the closing of our acquisition of Aratana.The liabilities were valued at $84.7 million as of the acquisition date using the Monte Carlo simulation model.The resulting $7.5 million loss upon settlement was recorded in other - net, expense in the consolidated and combined statement of operations for the year ended December 31, 2019.
loss upon settlement was recorded in Other - net, expense in the condensed consolidated and combined statement of operations for the three and nine months ended September 30, 2019.
The following table summarizes the preliminary amounts recognized for assets acquired and liabilities assumed as of the acquisition date:
| | | | | |
| Estimated Fair Value at July 18, 2019 | |
| Cash and cash equivalents | $ | 26.4 | |
| Inventories | 10.410.3 | |
| Acquired in-process research and development | 36.331.9 | |
Marketed products(1) | 37.136.7 | |
Other intangible assets(1) | 13.513.2 | |
| Other assets and liabilities - net | 25.423.2 | |
| Total identifiable net assets | 149.1141.7 | |
Goodwill(2) | 4.211.6 | |
| Settlement of existing contingent consideration liabilities | 84.7 | |
| Total consideration transferred | $ | 238.0 | |
(1)These intangible assets, which are being amortized on a straight-line basis over their estimated useful lives, are expected to have a weighted average useful life of approximately 12.5 years.
(2)The goodwill recognized from this acquisition is attributable primarily to expected synergies from combining the operations of Aratana with our legacy business. The majority of goodwill associated with this acquisition is not deductible for tax purposes.
The accounting for this acquisition is substantially complete, with the exception of the finalization of the valuation of inventory and intangible assets, as well astax-related amounts and minor working capital adjustments. No material measurement period adjustments were recorded during the three months ended March 31, 2020. The final determination of these amounts will be completed as soon as possible but no later than one year from the acquisition date.
We issued 0.1 million shares and recorded $3.6 million of stock-based compensation expense for the vesting of Aratana equity awards that was accelerated upon the closing of the acquisition during the three months ended September 30, 2019.
Our condensed consolidated statement of operations for the three months ended September 30, 2019 included revenues of $3.8 million from Aratana.
Had Aratana been acquired on January 1, 2018, the unaudited pro forma combined revenues and income before income taxes of Elanco and Aratana would have been $2.3 billion$735.1 million and $36.6 million, respectively, for both the ninethree months ended September 30, 2019 and September 30, 2018, and income before income taxes would have been $66.9 million and $98.9 million for the nine months ended September 30, 2019 and September 30, 2018, respectively.March 31, 2019.
Prevtec Microbia Inc.
On July 31, 2019, we acquired Prevtec in a cash transaction for approximately $60.3 million, inclusive of certain post-closing adjustments. Prevtec is a Canadian biotechnology company specializing in the development of vaccines intended to help prevent bacterial diseases in food animals. The acquisition allows us to expand on our previous distribution arrangement for ColiprotecColiprotec™® and is consistent with our efforts to explore innovative antibiotic alternatives.
The purchase consideration included up to $16.3 million in additional cash consideration, contingent upon the achievement of specific sales milestones by December 31, 2021. We have recorded a $4.7 million liability on the condensed consolidated balance sheet as of the acquisition date based on the fair value of the contingent consideration as calculated using the Monte Carlo simulation model.
A previously existing $0.7 million receivable owed from Prevtec to Elanco Animal Health UK Limited was settled upon the closing of our acquisition of Prevtec.The resulting immaterial gain upon settlement was recorded in other - net, expense in the consolidated and combined statement of operations for the year ended December 31, 2019.
The following table summarizes the preliminary amounts recognized for assets acquired and liabilities assumed as of the acquisition date:
| | | | | |
| Estimated Fair Value at July 31, 2019 | |
| Cash and cash equivalents | $ | 0.9 | |
| Property and equipment | 0.5 | |
| Acquired in-process research and development | 2.8 | |
Marketed products(1) | 59.158.9 | |
| Other intangible assets | 1.1 | |
| Other assets and liabilities - net | (9.8)(10.3) | |
| Total identifiable net assets | 54.653.9 | |
| |
Goodwill(2) | 10.411.1 | |
| Total consideration transferred | $ | 65.0 | |
(1)These intangible assets, which are being amortized on a straight-line basis over their estimated useful lives, are expected to have a weighted average useful life of 10 years.
(2)The goodwill recognized from this acquisition is attributable primarily to expected synergies from combining the operations of Prevtec with our legacy business and future unidentified projects and products. The goodwill associated with this acquisition is not deductible for tax purposes.
The accounting for this acquisition is substantially complete, with the exception of the finalization of the valuation of intangible assets, as well astax-related amounts and minor working capital adjustments. No material measurement period adjustments were recorded during the three months ended March 31, 2020. The final determination of these amounts will be completed as soon as possible but no later than one year from the acquisition date.
Pending Acquisition
Bayer Animal Health Business
On August 19, 2019, we entered into a Share and Asset Purchase Agreement (Purchase Agreement) with Bayer, Aktiengesellschaft (Bayer), a German corporation, to acquire Bayer's animal health business. Bayer's animal health business is a provider of products intended to improve the health and well-being of pets and farm animals. This acquisition is expected to expand our Companion Animal product category, advancing our planned intentional portfolio mix transformation and creating a better balance between our Food Animal and Companion Animal product categories. Pursuant to the Purchase Agreement and subject to the satisfaction of certain customary closing conditions, including the receipt of antitrust approvals and the absence of any law or order enjoining or otherwise prohibiting the transaction in specified jurisdictions, we will purchase Bayer’s animal health business for $5.3 billion in cash and approximately $2.3 billionshares of our common stock equal to approximately $2.3 billion divided by the 20-day volume-weighted average stock price as of the last day of trading before the closing of the acquisition (but subject to certain customary adjustments.a 7.5% symmetrical collar centered on the volume-weighted average price for the 30 trading days ended August 6, 2019 of $33.60). The transaction will close no earlier than July 1, 2020, per the terms of the Purchase Agreement. See Note 13: Commitments and Contingencies for discussion regarding certain commitments related to this transaction.
Divestitures
In January 2020, we signed agreements to divest the worldwide rights to Osurnia™ and the U.S. rights to Capstar™, and in February 2020, we signed an agreement to divest the worldwide rights to Vecoxan™, for an aggregate of $285 million in all cash transactions. The agreements were signed with the intent to advance our efforts to secure the necessary regulatory clearances for the pending acquisition of the Bayer animal health business. The closing of these transactions is contingent on us entering into consent decrees with certain agencies in connection with the pending acquisition as well as customary closing conditions. The divestitures are expected to close by mid-2020.
The related assets for all 3 divestitures met the assets held for sale criteria as of March 31, 2020 and the assets for the Osurnia and Capstar divestitures met the assets held for sale criteria as of December 31, 2019. No adjustments were required to record the assets at the lower of their carrying amounts or fair values less costs to sell on the condensed consolidated balance sheet. Assets and liabilities considered held for sale in connection with the divestitures were included in the respective line items on the consolidated balance sheet as follows:
| | | | | | | | | | | |
| March 31, 2020 | | December 31, 2019 |
| Inventories | $ | 6.2 | | | $ | 10.6 | |
| Other intangibles, net | 70.6 | | | 61.2 | |
| Property and equipment, net | 0.2 | | | 0.2 | |
| Total assets held for sale | $ | 77.0 | | | $ | 72.0 | |
| | | | |
| Deferred taxes | $ | (0.1) | | | $ | (1.4) | |
| Total liabilities held for sale | $ | (0.1) | | | $ | (1.4) | |
Other intangibles, net classified as held for sale primarily consist of marketed products. We determined that the disposal of these net assets does not qualify for reporting as a discontinued operation because it does not represent a strategic shift that has or will have a major effect on our operations and financial results.
Note 7. Asset Impairment, Restructuring and Other Special Charges
Our total charges related to asset impairment,
In recent years, we have incurred substantial costs associated with restructuring programs and other special charges, including integration of acquired businesses, in the unaudited condensed consolidated and combined statements of operations consisted of the following:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended September 30, | | | | Nine Months Ended September 30, | | |
| 2019 | | 2018 | | 2019 | | 2018 |
| Cash expense (income): | | | | | | | |
| Severance and other costs | $ | 10.4 | | | $ | (0.2) | | | $ | 9.6 | | | $ | (2.8) | |
| Integration and acquisition costs | 46.1 | | | 4.9 | | | 99.6 | | | 10.5 | |
| Facility exit costs | — | | | 1.5 | | | — | | | 11.2 | |
| Total cash expense | 56.5 | | | 6.2 | | | 109.2 | | | 18.9 | |
| Non-cash expense: | | | | | | | |
| | | | | | | |
| | | | | | | |
| Asset impairment | 10.2 | | | 6.2 | | | 14.2 | | | 63.9 | |
| Asset write-down | 10.5 | | | — | | | 10.5 | | | — | |
| Total non-cash expense | 20.7 | | 6.2 | | 24.7 | | 63.9 |
| Total expense | $ | 77.2 | | | $ | 12.4 | | | $ | 133.9 | | | $ | 82.8 | |
Restructuring
We historically participated in Lilly's cost-reduction initiatives which resulted in restructuring charges in the period priordesigned to our IPO. The restructuring costs include severanceachieve a flexible and other costs incurred as a result of actions taken to reduce ourcompetitive cost structure.
During September 2019, Restructuring activities primarily include charges associated with facility rationalization and workforce reductions. In connection with our recent acquisitions and the pending acquisition of Bayer's animal health business, we initiated a restructuring program to reducehave also incurred costs associated with executing transactions and support margin expansion. As a part of the restructuring program, the Company will eliminate certain positions across multiple locations and functions, including exiting research and developmentintegrating acquired operations, in Prince Edward Island, Canada, ceasing certain manufacturing operations in Wusi, China, and streamlining operations in Speke, England. The restructuring charge consisted of severance costs and non-cash asset write-down expenses. We expect to substantially complete the restructuring activities by September 2020.
Integration and acquisition costs
Integration and acquisition costs primarily represent charges and costs related to our integration efforts as a result of our acquired businesses, external costs directly related to acquiring businesses, including expenseswhich may include expenditures for banking, legal, accounting, and other similar services, andservices. In addition, we have incurred costs to stand up our organization up to beas an independent company.
Facility exit costs
Facility exit costs primarily represent contract termination costs and reserves for costs related to facilities which we have exited.
Asset impairment
Asset impairment recognized during the three and nine months ended September 30, 2019 resulted from the adjustment to fair value of property and equipment All operating functions can be impacted by these actions; therefore, non-cash expenses associated with our tangible and intangible assets that were subjectcan be incurred as a result of revised fair value projections and/or determinations to product rationalization.
Asset write-down
Asset write-down expenses recognized duringno longer utilize certain assets in the three and nine months ended September 30, 2019 resulted from the adjustments recorded to write assets classified as held for sale down to their current fair value.business on an ongoing basis.
For finite-lived intangible asset and other long-lived assets, whenever impairment indicators are present, we calculate the undiscounted value of projected cash flows associated with the asset, or group of assets, and compare it to the carrying amount. If the carrying amount is greater, we record an impairment loss for the excess of book value over fair value. Determinations of fair value can result from a complex series of judgments and rely on estimates and assumptions. See Note 2: Basis of Presentation and Summary of Significant Accounting Policies for discussion regarding estimates and assumptions.
Components of asset impairment, restructuring and other special charges are as follows:
| | | | | | | | | | | | | | | |
| | | | | Three Months Ended March 31, | | |
| | | | | 2020 | | 2019 |
Restructuring charges: (1) | | | | | | | |
| Severance and other costs | | | | | $ | 0.4 | | | $ | 0.5 | |
| Facility exit costs | | | | | 0.6 | | | — | |
| | | | | | | |
| Acquisition related charges: | | | | | | | |
Transaction and integration costs (2) | | | | | 76.3 | | | 20.4 | |
| | | | | | | |
| Non-cash and other items: | | | | | | | |
Asset impairment (3) | | | | | — | | | | 4.0 | |
Asset write-down (4) | | | | | 1.3 | | | | — | |
Gain on sale of fixed assets (5) | | | | | (3.8) | | | | — | |
| | | | | | | |
| Total expense | | | | | $ | 74.8 | | | $ | 24.9 | |
(1)For the three months ended March 31, 2020, these charges primarily relate to the announced 2019 program to streamline operations in Speke, England as well as the remaining costs to close the Larchwood, Iowa facility.
(2)Transaction costs represent external costs directly related to acquiring businesses and primarily include expenditures for banking, legal, accounting and other similar services. Integration costs represent internal and external incremental costs directly related to integrating acquired businesses, including the pending acquisition of Bayer's animal health business (e.g., expenditures for consulting, system and process integration, and product transfers), as well as stand-up costs related to the implementation of new systems, programs, and processes due to the Separation from Lilly.
(3)Asset impairment charges for the three months ended March 31, 2019 related to an adjustment to fair value of intangible assets that were subject to product rationalization.
(4)Asset write-down expenses for the three months ended March 31, 2020 result from adjustments recorded to write assets classified as held and used down to their current fair value. These charges primarily relate to fixed assets in Wusi, China in connection with the announced 2019 program to streamline operations.
(5)Represents a gain on the disposal from the sale of an R&D facility in Prince Edward Island, Canada, which was written down during the three months ended September 30, 2019 as part of the announced 2019 program to streamline operations.
The following table summarizes the activity in our reserves established in connection with restructuring activities:
| | Facility exit costs | | Severance | | Total | |
| Balance at December 31, 2017 | $ | 34.9 | | | $ | 43.1 | | | $ | 78.0 | | |
| Charges | 11.2 | | | (2.8) | | | 8.4 | | |
| Separation adjustment | (5.9) | | | | — | | | | (5.9) | | |
| Cash paid | (10.9) | | | (22.6) | | | (33.5) | | |
| Balance at September 30, 2018 | $ | 29.3 | | | $ | 17.7 | | | $ | 47.0 | | |
| | | | | | | | Facility exit costs | | Severance | | Total |
| Balance at December 31, 2018 | Balance at December 31, 2018 | $ | 9.3 | | | $ | 35.1 | | | $ | 44.4 | | Balance at December 31, 2018 | $ | 9.3 | | | $ | 35.1 | | | $ | 44.4 | |
| Charges | Charges | 20.7 | | | 20.0 | | | 40.7 | | Charges | — | | | 0.5 | | | 0.5 | |
| | Cash paid | | Cash paid | (0.3) | | | (7.3) | | | (7.6) | |
| Balance at March 31, 2019 | | Balance at March 31, 2019 | $ | 9.0 | | | $ | 28.3 | | | $ | 37.3 | |
| | Balance at December 31, 2019 | | Balance at December 31, 2019 | $ | 5.4 | | | $ | 15.5 | | | $ | 20.9 | |
| Charges | | Charges | 0.6 | | | 1.0 | | | 1.6 | |
| Reserve adjustments | Reserve adjustments | — | | | (10.2) | | | (10.2) | | Reserve adjustments | — | | | (0.6) | | | (0.6) | |
| Cash paid | Cash paid | (2.0) | | | (18.8) | | | (20.8) | | Cash paid | (1.0) | | | (9.8) | | | (10.8) | |
| Balance at September 30, 2019 | $ | 28.0 | | | $ | 26.1 | | | $ | 54.1 | | |
| Balance at March 31, 2020 | | Balance at March 31, 2020 | $ | 5.0 | | | $ | 6.1 | | | $ | 11.1 | |
These reserves are included in other current liabilities on the consolidated balance sheets. Substantially all of the reserves are expected to be utilizedpaid in the next twelve months. We believe that the reserves are adequate.
Note 8. Inventories
We state all inventories at the lower of cost or 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. FIFO cost approximates current replacement cost.
Inventories consisted of the following:
| | | September 30, 2019 | | December 31, 2018 | | March 31, 2020 | | December 31, 2019 |
| Finished products | Finished products | $ | 435.1 | | | $ | 400.7 | | Finished products | $ | 384.2 | | | $ | 402.9 | |
| Work in process | Work in process | 588.1 | | | 570.4 | | Work in process | 592.1 | | | 603.2 | |
| Raw materials and supplies | Raw materials and supplies | 84.6 | | | 80.4 | | Raw materials and supplies | 80.7 | | | 83.9 | |
| Total (approximates replacement cost) | Total (approximates replacement cost) | 1,107.8 | | | 1,051.5 | | Total (approximates replacement cost) | 1,057.0 | | | 1,090.0 | |
| Decrease to LIFO cost | Decrease to LIFO cost | (39.1) | | | (47.4) | | Decrease to LIFO cost | (38.0) | | | (39.3) | |
| Inventories | Inventories | $ | 1,068.7 | | | $ | 1,004.1 | | Inventories | $ | 1,019.0 | | | $ | 1,050.7 | |
Note 9. Equity
Common Stock Offering
On January 22, 2020, we entered into an underwriting agreement in which we agreed to sell approximately 22.7 million shares of our common stock at a public offering price of $32.00 per share. In connection with the offering, we granted the underwriters an option to purchase up to an additional 2.3 million shares, which was exercised in full on January 23, 2020. As a result, we issued and sold a total of approximately 25.0 million shares of our common stock for $767.5 million, after issuance costs.
Tangible Equity Unit (TEU) Offering
On January 22, 2020, we also completed our offering of 11 million, 5.00% TEUs. Total proceeds, net of issuance costs, were $528.5 million. Each TEU, which has a stated amount of $50, is comprised of a prepaid stock purchase contract (prepaid stock) and a senior amortizing note due February 1, 2023. Subsequent to issuance, each TEU may be legally separated into the two components. The prepaid stock is considered a freestanding financial instrument, indexed to Elanco common stock, and meets the conditions for equity classification.
The value allocated to the prepaid stock is reflected net of issuance costs in additional paid-in capital. The value allocated to the senior amortizing notes is reflected in long-term debt on the consolidated balance sheet, with payments expected in the next twelve months reflected in current portion of long-term debt. Issuance costs related to the amortizing notes are reflected as a reduction of the carrying amount and will be amortized through the maturity date using the effective interest rate method.
The proceeds from the issuance were allocated to equity and debt based on the relative fair value of the respective components of each TEU as follows:
| | | | | | | | | | | | | | | | | | | | |
| | Equity Component | | Debt Component | | Total |
| Fair value per unit | | $ | 42.80 | | | $ | 7.20 | | | $ | 50.00 | |
| | | | | | |
| Gross proceeds | | $ | 470.8 | | | $ | 79.2 | | | $ | 550.0 | |
| Less: Issuance costs | | 18.4 | | | 3.1 | | | 21.5 | |
| Net proceeds | | $ | 452.4 | | | $ | 76.1 | | | $ | 528.5 | |
The senior amortizing notes have an aggregate principal amount of $79.2 million and bear interest at 2.75% per year. On each February 1, May 1, August 1, and November 1 until the maturity date, we will pay equal quarterly cash installments of $0.6250 per each amortizing note with an initial principal amount of $7.2007 (except for the first
installment payment of $0.6528 per amortizing note due on May 1, 2020). Each installment constitutes a payment of interest and partial payment of principal, and in the aggregate will be equivalent to 5.00% per year with respect to the $50 stated amount per TEU.
Unless settled early at the holder’s or our election, each prepaid stock purchase contract will automatically settle on February 1, 2023 (the mandatory settlement date) for a number of shares of common stock per contract based on the average of the volume-weighted average trading prices during the 20 consecutive trading day period beginning on, and including the 21st scheduled trading day immediately preceding February 1, 2023 (applicable market value) with reference to the following settlement rates:
| | | | | | | | |
| Applicable Market Value | | Common Stock Issued |
| Equal to or greater than $38.40 | | 1.3021 shares (minimum settlement rate) |
| Less than $38.40, but greater than $32.00 | | $50 divided by applicable market value |
| Less than or equal to $32.00 | | 1.5625 (maximum settlement rate) |
The prepaid stock purchase contracts are mandatorily convertible into a minimum of 14.3 million shares or a maximum of 17.2 million shares of our common stock on the mandatory settlement date (unless redeemed by us or settled earlier at the unit holder's option). The 14.3 million minimum shares are included in the calculation of basic weighted average shares outstanding. The difference between the minimum and maximum shares represents potentially dilutive securities, which are included in the calculation of diluted weighted average shares outstanding on a pro rata basis to the extent that the average applicable market value is higher than $32.00 but is less than $38.40 during the period.
Note 10. Debt
Long-term debt consisted of the following:
| | | September 30, 2019 | | December 31, 2018 | | March 31, 2020 | | December 31, 2019 |
| | Term credit facility | Term credit facility | $ | 377.5 | | | $ | 492.5 | | Term credit facility | $ | — | | | $ | 371.4 | |
| 3.912% Senior Notes due 2021 | 3.912% Senior Notes due 2021 | 500.0 | | | 500.0 | | 3.912% Senior Notes due 2021 | 500.0 | | | 500.0 | |
| 4.272% Senior Notes due 2023 | 4.272% Senior Notes due 2023 | 750.0 | | | 750.0 | | 4.272% Senior Notes due 2023 | 750.0 | | | 750.0 | |
| 4.900% Senior Notes due 2028 | 4.900% Senior Notes due 2028 | 750.0 | | | 750.0 | | 4.900% Senior Notes due 2028 | 750.0 | | | 750.0 | |
| TEU amortizing notes | | TEU amortizing notes | 79.2 | | | — | |
| Other obligations | Other obligations | 0.3 | | | 0.5 | | Other obligations | 0.3 | | | 0.4 | |
| Unamortized debt issuance costs | Unamortized debt issuance costs | (17.7) | | | (20.7) | | Unamortized debt issuance costs | (17.9) | | | (16.8) | |
| | Total debt | Total debt | 2,360.1 | | | 2,472.3 | | Total debt | 2,061.6 | | | 2,355.0 | |
| Less current portion of long-term debt | Less current portion of long-term debt | 24.5 | | | 29.0 | | Less current portion of long-term debt | 26.0 | | | 24.5 | |
| Total long-term debt | Total long-term debt | $ | 2,335.6 | | | $ | 2,443.3 | | Total long-term debt | $ | 2,035.6 | | | $ | 2,330.5 | |
TEU Amortizing Notes
On January 22, 2020, we issued $550 million in TEUs. We offered 11 million, 5.00% TEUs at the stated amount of $50 per unit, comprised of prepaid stock purchase contracts and a senior amortizing note due February 1, 2023 (the mandatory settlement date). Total cash of $528.5 million was received, comprised of $452.4 million of prepaid stock purchase contracts and $76.1 million of senior amortizing notes, net of issuance costs. See Note 9: Equity for further information.
Term Loan Extinguishment
On January 31, 2020, we repaid indebtedness outstanding under our existing term loan facility. We paid $372.4 million in cash, composed of $371.4 million of principal and $1.0 million of accrued interest, resulting in a debt extinguishment loss of $0.8 million (recognized in interest expense in the condensed consolidated statement of operations for the three months ended March 31, 2020) primarily related to the write-off of deferred debt issuance costs.
New Credit Facility
On February 4, 2020, we successfully priced our senior secured credit facilities, consisting of the following:
•Term loan B facility with an aggregate principal amount of $4,275.0 million and a maturity of seven years.
•Revolving credit facility providing up to $750.0 million and a maturity of five years.
The term loan B facility was priced at par at LIBOR plus 175 basis points, and the revolving loan facility is expected to bear interest at LIBOR plus an applicable margin ranging between 1.50% and 2.25% per annum based on our corporate family rating or corporate credit rating.
We intend to use the proceeds from the equity and debt activities to finance the cash portion of the pending acquisition of Bayer's animal health business and to pay related fees and expenses. As a result, we have obtained substantially all of the financing necessary to consummate the acquisition and do not currently intend to pursue any additional financing previously provided under the commitment letter obtained in August 2019 (see Note 13: Commitments and Contingencies). We expect to execute the debt agreements upon closing the acquisition of Bayer's animal health business.
The senior secured credit facilities are expected to include two financial maintenance covenants which are solely for the benefit of lenders under the revolving credit facility and no financial maintenance covenant for the benefit of the term loan B facility. The lenders under the term loan B facility will have no enforcement rights with respect to the financial maintenance covenants for the revolving credit facility.
We expect the first financial maintenance covenant for the revolving credit facility to be a requirement to maintain a certain pro forma net total leverage ratio level (which will not be subject to step-downs) as of the end of each quarter, beginning with the fiscal quarter ending September 30, 2020 (assuming the closing of the acquisition of Bayer's animal health business occurs on July 1, 2020). The required level of this covenant will be based on closing date pro forma net leverage and pro forma adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) equal to 65% of our pro forma adjusted EBITDA for the four fiscal quarters ending March 31, 2020 (assuming the closing of the acquisition of Bayer's animal health business occurs on July 1, 2020).
The second financial maintenance covenant for the revolving credit facility is expected to be a requirement to maintain a ratio of pro forma adjusted EBITDA to cash interest expense of no less than 2.00 to 1.00, tested as of the end of each fiscal quarter, beginning with the fiscal quarter ending September 30, 2020 (assuming the closing of the acquisition of Bayer's animal health business occurs on July 1, 2020).
Note 10.11. Financial Instruments and Fair Value
Financial instruments that are potentially subject to credit risk consist principally of trade receivables. Collateral is generally not required. The risk associated with this concentration is mitigated by our ongoing credit-review procedures and insurance.procedures.
A large portion of our cash is held in a few major financial institutions. We monitor the exposure with these institutions and do not expect any of these institutions to fail to meet their obligations. All highly liquid investments with a maturity of three months or less from the date of purchase are considered to be cash equivalents. The cost of these investments approximates fair value. We also consider the carrying value of restricted cash balances to be representative of its fair value.
As of September 30, 2019March 31, 2020 and December 31, 2018,2019, we had $17.9$20.0 million and $15.3$18.8 million, respectively, ofprimarily related to equity method investments included in other noncurrent assets inon our condensed consolidated balance sheet.
The following table summarizes the fair value information at September 30, 2019March 31, 2020 and December 31, 20182019 for long-term debt as well as forforeign exchange contract assets (liabilities), contingent consideration liabilities, and the net investment hedge asset (liability)assets (liabilities) and cash flow hedge assets (liabilities) measured at fair value on a recurring basis in the respective balance sheet line items:items, as well as long-term debt (including TEU amortizing notes) for which fair value is disclosed on a recurring basis:
| | | | | | Fair Value Measurements Using | | | | | | | Fair Value Measurements Using | | | |
| Financial statement line item | Financial statement line item | Carrying
Amount | | Quoted Prices in Active Markets for Identical Assets
(Level 1) | | Significant
Other Observable Inputs
(Level 2) | | Significant
Unobservable
Inputs
(Level 3) | | Fair
Value | Financial statement line item | Carrying
Amount | | Quoted Prices in Active Markets for Identical Assets
(Level 1) | | Significant
Other Observable Inputs
(Level 2) | | Significant
Unobservable
Inputs
(Level 3) | | Fair
Value |
| September 30, 2019 | | | | | | | | | | |
| March 31, 2020 | | March 31, 2020 | | | | | | | | | |
| Prepaid expenses and other - foreign exchange contracts not designated as hedging instruments | | Prepaid expenses and other - foreign exchange contracts not designated as hedging instruments | $ | 28.0 | | | $ | — | | | $ | 28.0 | | | $ | — | | | $ | 28.0 | |
| Other current liabilities - foreign exchange contracts not designated as hedging instruments | | Other current liabilities - foreign exchange contracts not designated as hedging instruments | (8.2) | | | — | | | (8.2) | | | — | | | (8.2) | |
| Other noncurrent liabilities - contingent consideration | | Other noncurrent liabilities - contingent consideration | (4.7) | | | — | | | — | | | (4.7) | | | (4.7) | |
| Other noncurrent assets - cross currency interest rate contracts designated as net investment hedges | | Other noncurrent assets - cross currency interest rate contracts designated as net investment hedges | 6.6 | | | — | | | 6.6 | | | — | | | 6.6 | |
| Other noncurrent liabilities - forward-starting interest rate contracts designated as cash flow hedges | | Other noncurrent liabilities - forward-starting interest rate contracts designated as cash flow hedges | (50.6) | | | — | | | (50.6) | | | — | | | (50.6) | |
| Long-term debt - senior notes | | Long-term debt - senior notes | (2,000.0) | | | — | | | (2,067.3) | | | — | | | (2,067.3) | |
| TEU amortizing note (1) | | TEU amortizing note (1) | (79.2) | | | — | | | (79.2) | | | — | | | (79.2) | |
| December 31, 2019 | | December 31, 2019 | |
| Prepaid expenses and other - foreign exchange contracts not designated as hedging instruments | | Prepaid expenses and other - foreign exchange contracts not designated as hedging instruments | $ | 0.8 | | | $ | — | | | $ | 0.8 | | | $ | — | | | $ | 0.8 | |
| Other current liabilities - foreign exchange contracts not designated as hedging instruments | | Other current liabilities - foreign exchange contracts not designated as hedging instruments | (1.1) | | | — | | | (1.1) | | | — | | | (1.1) | |
| Other noncurrent liabilities - contingent consideration | Other noncurrent liabilities - contingent consideration | $ | (4.7) | | | $ | — | | | $ | — | | | $ | (4.7) | | | $ | (4.7) | | Other noncurrent liabilities - contingent consideration | (4.7) | | | — | | | — | | | (4.7) | | | (4.7) | |
| Other noncurrent assets/(liabilities) - cross currency interest rate contracts designated as net investment hedges | 22.8 | | | — | | | 22.8 | | | — | | | 22.8 | | |
| Other noncurrent assets - cross currency interest rate contracts designated as net investment hedges | | Other noncurrent assets - cross currency interest rate contracts designated as net investment hedges | 2.3 | | | — | | | 2.3 | | | — | | | 2.3 | |
| | Long-term debt - senior notes | Long-term debt - senior notes | (2,000.0) | | | — | | | (2,120.0) | | | — | | | (2,120.0) | | Long-term debt - senior notes | (2,000.0) | | | — | | | (2,120.6) | | | — | | | (2,120.6) | |
| December 31, 2018 | | |
| Other current liabilities - contingent consideration | $ | (5.1) | | | $ | — | | | $ | — | | | $ | (5.1) | | | $ | (5.1) | | |
| Other noncurrent liabilities - contingent consideration | (69.0) | | | — | | | — | | | (69.0) | | | (69.0) | | |
| Other noncurrent assets/(liabilities) - cross currency interest rate contracts designated as net investment hedges | (7.4) | | | — | | | (7.4) | | | — | | | (7.4) | | |
| Long-term debt - senior notes | (2,000.0) | | | — | | | (2,005.0) | | | — | | | (2,005.0) | | |
Long-term debt - term credit facility (1) | | Long-term debt - term credit facility (1) | (371.4) | | | — | | | (371.4) | | | — | | | (371.4) | |
|
(1)We consider the carrying value to be representative of its fair value.
We determine our Level 2 fair value measurements based on a market approach using quoted market values or significant other observable inputs for identical or comparable assets or liabilities.
Contingent consideration liabilities as of September 30,March 31, 2020 and December 31, 2019 related to contingent consideration associated with the acquisitionacquisitions of Aratana and Prevtec during 2019. For Aratana, we will pay up to
$12 million in contingent value rights that are dependent on the period. Basedachievement of a specified milestone as outlined in the merger agreement. For Prevtec, based on the terms of the purchase agreement, we will pay up to $16.3 million contingent upon the achievement of specific Coliprotec sales milestones by December 31, 2021. The fair value of both contingent consideration liabilities was estimated using the Monte Carlo simulation model and Level 3 inputs including historical revenue, discount rate, asset volatility, and revenue volatility. See Note 6: Acquisitions and Divestitures for further discussion.
Contingent consideration liabilitiesWe are exposed to market risks, such as of December 31, 2018changes in foreign currency exchange rates and interest rates. To manage the volatility related to Galliprantthese exposures, 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 whichas an accounting hedge at inception. Additionally, we assess, both at inception and at least quarterly thereafter, whether the financial instruments used in the hedging transaction are effective at offsetting changes in either the fair value was estimated using a discountedvalues or cash flow analysis and Level 3 inputs, including projections representativeflows of a market participant view for the probability of achieving potential future payments to Aratana and an estimated discount rate. The amount to be paidunderlying exposures.
Derivatives Not Designated as of December 31, 2018 was dependent upon certain development, success-based regulatory, and sales-based milestones. These liabilities were settled upon the closing of our acquisition of Aratana on July 18, 2019. See Note 6: Acquisitions for further discussion.Hedges
The Senior Notes are comprised of $500.0 million of 3.912% Senior Notes due August 27, 2021, $750.0 million of 4.272% Senior Notes due August 28, 2023, and $750.0 million of 4.900% Senior Notes due August 28, 2028.
We have a term credit facilitymay enter into foreign exchange forward or option contracts to reduce the effect of $377.5 millionfluctuating currency exchange rates. These derivative financial instruments primarily offset exposures in the British pound, Canadian dollar, Euro, Japanese yen and $492.5 million, respectively,Swiss franc (CHF). 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 amortized costfair value with the gain or loss recognized in our condensed consolidated balance sheets as of September 30, 2019other – net, (income) expense. Forward contracts generally have maturities not exceeding 12 months. At March 31, 2020 and December 31, 2018. We consider2019, we had outstanding foreign exchange contracts with aggregate notional amounts of $898.4 million and $861.2 million, respectively. During the carrying valuethree months ended March 31, 2020 and 2019, the amount of net gains and losses on derivative instruments not designated as hedging instruments, recorded in other – net, (income) expense were $(28.0) million and $8.0 million, respectively. These amounts were substantially offset in other – net, (income) expense by the term credit facility to be representativeeffect of its fair valuechanging exchange rates on the underlying foreign currency exposures.
Derivatives Designated as of September 30, 2019 and December 31, 2018. The fair value of this term credit facility is estimated based on quoted market prices of similar liabilities and is classified as Level 2.Hedges
In October 2018, as a means of mitigating the impact of currency fluctuations on our operations in Switzerland, we entered into a five-year cross-currency fixed interest rate swap with a 750 million Swiss franc (CHF)CHF notional amount, which is designated as a net investment hedge (NIH) against CHF denominated assets for which the(the fair value of which was estimated based on quoted market values of similar hedges and is classified as Level 2. The NIH is expected to generate approximately $25 million in cash and an offset to interest expense on an annual basis.2). During the three and nine months ended September 30,March 31, 2020 and 2019 our interest expense was offset by $6.2$6.0 million and $18.4$6.1 million, respectively, as a result of the NIH. Over the life of the derivative, gains or losses due to spot rate fluctuations are recorded in cumulative translation adjustment.adjustment in other comprehensive income. During the three months ended September 30,March 31, 2020 and 2019, we recorded a gain, net of $18.5tax, of $23.3 million and $12.2 million, respectively, on the NIH. In March 2020, approximately 75% of our cross-currency swaps were liquidated for a cash benefit of $26.7 million (including $1.5 million in interest). We had an approximately 190 million CHF notional remaining on our NIH as of March 31, 2020. In April 2020, we liquidated our remaining position for a cash benefit of $8.3 million. Notwithstanding settlement, gains and losses within accumulated other comprehensive income loss will remain in accumulated other comprehensive loss until either the sale or substantial liquidation of the hedged subsidiary.
Separately, in March 2020, as a means of mitigating variability in cash flows associated with the anticipated term loan B issuance, we executed forward-starting interest rate swaps with a $4.05 billion notional amount, which are designated as cash flow hedges and have settlement dates ranging between 2022 and 2025. These instruments effectively convert floating-rate debt to fixed-rate debt. The cash flow hedges are recorded at fair value on our condensed consolidated balance sheet, while changes in the fair value of the hedge are recognized in other comprehensive income. Fair value is estimated based on quoted market values of similar hedges and is classified as Level 2. Amounts recorded in accumulated other comprehensive loss will be recognized in earnings in interest expense when the hedged transaction affects earnings (i.e., when interest payments are accrued on the term loan B). During the three months ended March 31, 2020, we recorded a loss of $39.2 million, net of tax benefit of $11.4 million, on the NIH, which is included in the change in the cumulative translation adjustmentcash flow hedges in other comprehensive income. There is a potential for significant 2023 settlement exposure as the U.S. dollar fluctuates against the Swiss franc. The risk management objective is to manage foreign currency risk relating to net investments in certain CHF denominated assets. Changes in fair value of the derivative instruments are recognized as a component of accumulated other comprehensive loss to offset the changes in the values of the net investments being hedged.loss.
Note 11. Leases
We determine if an arrangement is a lease at inception. We have operating leases for corporate offices, research and development facilities, vehicles, and equipment. Our leases have remaining lease terms of one to 12 years, some of which have options to extend or terminate the leases. Finance leases are included in property and equipment, current portion of long-term debt, and long-term debt in our condensed consolidated balance sheet. Finance leases are not material to our condensed consolidated statements of operations, condensed consolidated balance sheet, or condensed consolidated statement of cash flows. Beginning January 1, 2019, operating leases are included in noncurrent assets, other current liabilities, and other noncurrent liabilities in our consolidated balance sheet.
Right-of-use assets included in noncurrent assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Right-of-use assets and operating lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. We use the implicit rate if it is readily determinable. The right-of-use asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain and there is a significant economic incentive to exercise that option.
Operating lease expense for right-of-use assets is recognized on a straight-line basis over the lease term. Variable lease payments, which represent lease payments that vary due to changes in facts or circumstances occurring after the commencement date other than the passage of time, are expensed in the period in which the obligation for these payments was incurred.
We elected not to apply the recognition requirements of ASC 842, Leases, to short-term leases, which are deemed to be leases with a lease term of 12 months or less. Instead, we recognize lease payments in the condensed consolidated statements of operations on a straight-line basis over the lease term and variable payments in the period in which the obligation for these payments are incurred. We elected this policy for all classes
of underlying assets. We elected not to apply the practical expedient related to the separation of lease and non-lease components or the practical expedient which allows entities to use hindsight when determining lease term.
The impact of operating leases to our condensed consolidated financial statements was as follows:
| | | | | | | | | | | | |
| Three months ended September 30, 2019 | | Nine months ended September 30, 2019 | |
| Lease cost | | | | |
| Operating lease cost | $ | 6.7 | | | $ | 19.0 | | |
| Short-term lease cost | 0.1 | | | 0.5 | | |
| Variable lease cost | 0.5 | | | 1.6 | | |
| Total lease cost | $ | 7.3 | | | $ | 21.1 | | |
| | | | |
| Other information | | | | |
| Operating cash outflows from operating leases | | | $ | 17.9 | | |
| Right-of-use assets obtained in exchange for new operating lease liabilities | | | 2.0 | | |
| Weighted-average remaining lease term - operating leases | | | 4.9 years | |
| Weighted-average discount rate - operating leases | | | 4.2 | % | |
| | | | |
Supplemental balance sheet information related to our operating leases is as follows:
| | | | | | | | | | | |
| Balance Sheet Classification | | September 30, 2019 |
Right-of-use assets | Other noncurrent assets | | $ | 81.7 | |
Current operating lease liabilities | Other current liabilities | | 24.1 | |
Non-current operating lease liabilities | Other noncurrent liabilities | | 57.6 | |
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As of September 30, 2019, the annual minimum lease payments of our operating lease liabilities were as follows:
| | | | | |
Year 1 | $ | 25.3 | |
Year 2 | 20.1 | |
Year 3 | 11.5 | |
Year 4 | 9.0 | |
Year 5 | 7.0 | |
After Year 5 | 14.9 | |
Total lease payments | 87.8 | |
Less imputed interest | (6.1) | |
Total | $ | 81.7 | |
Note 12. Income Taxes
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Provision for Taxes on Income | | Three Months Ended September 30, | | | | Nine Months Ended September 30, | | |
| | 2019 | | 2018 | | 2019 | | 2018 |
| (Benefit) Provision for Taxes on Income | | $ | (22.5) | | | $ | 18.6 | | | $ | 5.1 | | | $ | 46.2 | |
| Effective Tax Rate | | 179.7 | % | | 23.6 | % | | 6.2 | % | | 39.7 | % |
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| Provision for Taxes on Income | | | | | | Three Months Ended March 31, | | |
| | | | | | 2020 | | 2019 |
| (Benefit) Provision for Taxes on Income | | | | | | $ | (18.7) | | | $ | 13.3 | |
| Effective Tax Rate | | | | | | 27.6 | % | | 29.7 | % |
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During the periods presented in the condensed consolidated and combined financial statements for the three and nine months ended September 30, 2018, our operations were generally included in the tax grouping of other Lilly entities within the respective entity's tax jurisdiction; however, in certain jurisdictions, we filed separate tax returns. Our income taxes for the three months ended March 31, 2019 and nine month periods ended September 30, 20192020, respectively, reflect the results on a stand-alone basis independent of Lilly, except for the period during which we were included in a combined tax return until full separation. In the jurisdictions in which we were included in a combined tax return, our income taxes were determined based on the tax matters agreement between us and Lilly. Prior to the Separation, the income tax expense included in these financial statements has been calculated using the separate return basis as if Elanco filed separate tax returns.
In 2017, the U.S. enacted the Tax Cuts and Jobs Act (2017 Tax Act), which significantly revised U.S. tax law. Guidance related to the 2017 Tax Act, including Notices, Proposed Regulations, and Final Regulations, has been issued, and we expect additional guidance will be issued in 2019.2020. This additional guidance could materially impact our assumptions and estimates used to record our U.S. federal and state income tax expense resulting from the 2017 Tax Act.
We are included in Lilly's 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 the 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. Certain mattersDuring the fourth quarter of Lilly’s U.S.2019, the IRS began its examination of tax years 20132016 - 2015 effectively settled during2018. Because the examination is still in the early stages of information gathering, the resolution of the audit will likely extend beyond the next 12 months.
For the three months ended June 30, 2019 and the resulting adjustments will not require any cash tax payments by Elanco. The examination for tax year 2015 remains ongoing, but Lilly anticipates the remaining matters will be effectively settled in the fourth quarter of 2019.Lilly’s U.S. examination of tax years 2016-2018 is expected to begin in the fourth quarter of 2019.
For the three and nine months ended September 30, 2019,March 31, 2020, we recognized an income tax benefit of $22.5 million and incurred $5.1 million of income tax expense, respectively. For the three and nine months ended September 30, 2019, our$18.7 million. The effective tax rate of 27.6% differs from the statutory income tax rate primarily due to a discrete tax benefit from the resolution ofpre-tax book loss mainly driven by acquisition and integration costs. In addition, a Brazil tax audit in addition to the impact of lower pre-tax earnings largely due to restructuring charges. Tax reserves had been established in the 2015 acquisition of Novartis Animal Health (Novartis) and were partially covered by an indemnity. The favorable resolution of the Brazil tax audit resulted in andiscrete income tax benefit of approximately $14$1.9 million was recognized related to the excess tax benefits for stock-based compensation that vested in the third quarter of 2019.three months ended March 31, 2020.
For the three and nine months ended September 30, 2018,March 31, 2019, we incurred $18.6$13.3 million and $46.2 million, respectively, of income tax expense. ForThe effective rate for the three and nine months ended September 30, 2018, our effective tax rate differsMarch 31, 2019, of 29.7% was different from the statutory income tax rate primarily due to no benefits being recorded for losses incurreda one-time foreign exchange gain on the transfer of assets upon separation in addition to the U.S. for asset impairments and contractual commitment charges associated with the suspensionimpact of commercial activities of Imrestor® due to full valuation allowances recorded in the United States.state income taxes.
Note 13. Commitments and Contingencies
Legal matters
We are party to various legal actions in the normal course of business. In determining whether a pending matter is significant for financial reporting and disclosure purposes, we consider both quantitative and qualitative factors in order to assess materiality. We record aaccrue for certain liability for claims to the extent that we can formulate a reasonable estimate of their costs and there is a reasonable probability of incurring significant costs or expenses. At September 30, 2019March 31, 2020 and December 31, 2018,2019, we had 0 liabilities established related to litigation as there were no significant claims
which were probable and estimable. We have not historically had any significant litigation expense and are not currently subject to a significant claim.
Bayer Animal Health acquisition financing
In connection with our pending acquisition of the animal health business of Bayer as discussed in Note 6: Acquisitions and Divestitures, in August 2019, we entered into a commitment letter that provides for financing consisting of up to $750 million in a revolving facility, $3.0 billion in a term facility and $2.75 billion in a senior secured bridge facility. The revolving facility, term facility, and bridge facility are subject to customary terms, conditions, and financial covenants. If drawn upon, the proceeds will be used to fund a portion of the cash to be paid in the pending acquisition of the animal health business of Bayer and the payment of related fees and expenses. The revolving facility will mature five years after the closing date of the acquisition and the term facility and bridge facility will mature seven years after the closing date of the acquisition. In connection with the financing commitment letter, we will incur fixed commitment fees of $40.4 million that will become due and payable upon the closing of the pending acquisition or the termination of the Purchase Agreement with Bayer. These fees have not been recorded on the condensed consolidated balance sheet as of September 30, 2019.March 31, 2020. As a result of the financing secured for the acquisition through the equity and debt activity
during the three months ended March 31, 2020, we no longer intend to use the full financing pursuant to the commitment letter. See Note 9: Equity and Note 10: Debt for more information.
Note 14. Geographic Information
We operate as a single operating segment engaged in the development, manufacturing, marketing and sales of animal health products worldwide for both food animals and companion animals. Consistent with our operational structure, our President and Chief Executive Officer (CEO), as the chief operating decision maker, makes resource allocation and business process decisions globally across our consolidated business. Strategic decisions are managed globally with global functional leaders responsible for determining significant cost/investments and with regional leaders responsible for overseeing the execution of the global strategy. Our global research and development organization is responsible for development of new products. Our manufacturing organization is responsible for the manufacturing and supply of products and for the optimization of our supply chain. Regional leaders are responsible for the distribution and sale of our products and for local direct costs. The business is also supported by global corporate staff functions. Managing and allocating resources at the global corporate level enables our CEO to assess the overall level of resources available and how to best deploy these resources across functions, product types, regional commercial organizations and research and development projects in line with our overarching long-term corporate-wide strategic goals, rather than on a product or geographic basis. Consistent with this decision-making process, our CEO uses consolidated, single-segment financial information for purposes of evaluating performance, allocating resources, setting incentive compensation targets, as well as forecasting future period financial results.
Our products include Rumensin®Rumensin™, Optaflexx®Optaflexx™, Denagard®Denagard™, Tylan®Tylan™, Maxiban®Maxiban™ and other products for livestock and poultry, as well as Trifexis®Trifexis™, Interceptor™, Interceptor®Comfortis™, Comfortis®, Galliprantand other products for companion animals.
We have a single customer that accounted for 15.9%13.6% and 11.1%12.3% of revenue for the three months ended September 30,March 31, 2020 and 2019, and 2018, respectively, and for 13.4% and 11.5% of revenue for the nine months ended September 30, 2019 and 2018, respectively. The product sales resulted in accounts receivable with this customer of $124.5$87.5 million and $96.4$90.5 million as of September 30, 2019March 31, 2020 and December 31, 2018,2019, respectively.
We are exposed to the risk of changes in social, political and economic conditions inherent in foreign operations and our results of operations and the value of our foreign assets are affected by fluctuations in foreign currency exchange rates.
Selected geographic area information was as follows:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | 2019 | | 2018 | | | | 2020 | | 2019 |
Revenue—to unaffiliated customers(1) | Revenue—to unaffiliated customers(1) | | | | | | | | Revenue—to unaffiliated customers (1) | | | | | |
| United States | United States | $ | 388.2 | | | $ | 382.2 | | | $ | 1,167.1 | | | $ | 1,108.6 | | United States | | | $ | 299.9 | | | $ | 383.9 | |
| International | International | 383.1 | | | 378.9 | | | 1,116.9 | | | 1,158.9 | | International | | | 357.8 | | | 347.2 | |
| | Revenue | Revenue | $ | 771.3 | | | $ | 761.1 | | | $ | 2,284.0 | | | $ | 2,267.5 | | Revenue | | | $ | 657.7 | | | $ | 731.1 | |
| | | September 30, 2019 | | December 31, 2018 | | March 31, 2020 | | December 31, 2019 |
Long-lived assets(2) | Long-lived assets(2) | | | | Long-lived assets (2) | | | |
| United States | United States | $ | 637.2 | | | $ | 602.6 | | United States | $ | 732.7 | | | $ | 709.8 | |
| United Kingdom | United Kingdom | 181.8 | | | 187.5 | | United Kingdom | 181.8 | | | 192.6 | |
| | Other foreign countries | Other foreign countries | 208.6 | | | 195.8 | | Other foreign countries | 232.9 | | | 244.7 | |
| Long-lived assets | Long-lived assets | $ | 1,027.6 | | | $ | 985.9 | | Long-lived assets | $ | 1,147.4 | | | $ | 1,147.1 | |
(1)Revenue is attributed to the countries based on the location of the customer.
(2)Long-lived assets consist of property and equipment, net, and certain noncurrent assets, including right-of-use assets.
Note 15. Retirement Benefits
Pension plan amendment
In September 2019, we signed agreements under which certain defined pension benefits in Switzerland will transfer from the current Lilly pension fund as of December 31, 2019 to a new Elanco pension fund effective January 1, 2020. This resulted in a plan amendment during the period. The plan amendment decreased our pension benefit obligation by approximately $21 million, consisting primarily of a decrease in prior service costs of approximately $75 million, partially offset by a loss of approximately $54 million driven by changes in certain assumptions. The net impact to accumulated other comprehensive income was a gain of approximately $21 million, which will be amortized over the average remaining service period of employees expected to receive benefits under the plans.
Note 16.15. Earnings Per Share
As discussed in Note 1, Elanco Parent was formed for the purpose of facilitating the IPO. Lilly held all shares of Elanco Parent from the time of formation until the IPO.
Prior to IPO, there were an aggregate of 293,290,000 shares of our common stock held by Lilly (which represents the 100 shares held by Lilly prior to giving effect to the 2,932,900-for-1 stock split that occurred on September 19, 2018). In connection with the completion of the IPO, an additional 72,335,000 shares were issued.Basic Earnings per share was calculated based on the assumption that the shares held by Lilly were outstanding for all periods prior to IPO.Per Share
We compute basic earnings (loss) per share by dividing net earnings (loss) available to common shareholders by the actual weighted average number of common shares outstanding for the reporting period. Diluted earnings per share reflects the potential dilution that could occur if holders of unvested restricted stock units and stock options converted their holdings into common stock. For the three and nine months ended September 30, 2019,March 31, 2020, weighted average number of common shares outstanding used to calculate basic earnings per share includes the impact of approximately 7.325.0 million shares that wereand 14.3 million shares relating to the common stock issued during the period in connection with the acquisitionJanuary 2020 common stock offering and the shares of Aratana.common stock issuable at the minimum settlement rate under the TEU prepaid stock purchase contracts, respectively. See Note 6: Acquisitions9: Equity for further discussion.
Diluted Earnings Per Share
Elanco has variable common stock equivalents relating to certain equity awards in stock-based compensation arrangements and the TEU prepaid stock purchase contracts. Diluted earnings per share reflects the potential dilution that could occur if holders of the unvested equity awards and unsettled TEUs converted their holdings into common stock. The weighted average number of potentially dilutive shares outstanding is calculated using the treasury stock method.
Weighted average diluted shares outstanding included common stock equivalents of 0.3 million for the three months ended March 31, 2019.
Potential common shares that would have the effect of increasing diluted earnings per share are considered to be anti-dilutive and as such, these shares are not included in the calculation of diluted earnings per share. For both
During the three months ended March 31, 2020, we reported a net loss. Therefore, dilutive common shares are not assumed to have been issued since their effect is anti-dilutive.
For the three and nine months ended September 30,March 31, 2019, approximately 0.10.2 million shares of potential common shares were excluded from the calculation of diluted earnings per share because their effect was anti-dilutive.
Note 17.16. Related Party Agreements and Transactions
Transactions with Lilly Subsequent to Separation and Related to the Separation
Amounts due from/(due to) Lilly in connection with the Separation and agreed upon services were as follows:
| | | | | | | | | | | |
| September 30, 2019 | | December 31, 2018 |
| TSA | $ | (18.1) | | | $ | (28.0) | |
| Other activities | (29.2) | | | (38.0) | |
| Local country asset purchases | (11.1) | | | (202.7) | |
| Total receivable from/(payable to) Lilly | $ | (58.4) | | | $ | (268.7) | |
| | | | | | | | | | | |
| March 31, 2020 | | December 31, 2019 |
| TSA | $ | 10.8 | | | $ | 10.5 | |
| Other activities | 8.6 | | | (15.8) | |
| Local country asset purchases | (10.7) | | | (11.1) | |
| Total receivable from/(payable to) Lilly | $ | 8.7 | | | $ | (16.4) | |
As described in Note 1, we completed an IPO in September 2018 and Lilly fully divested of all ownership of Elanco in March 2019. In connection with the Separation, we entered into various agreements with Lilly related to the form of our separation and certain ongoing activities that will continue for a period of time. These included, among others, a master separation agreement (MSA), a TSA and a tax matters agreement. In addition, there was a portion of our operations for which the legal transfer of our net assets did not occur prior to the Separation due to certain regulatory requirements in each of these countries.
Transitional Services Agreement (TSA)
Historically, Lilly has provided us significant shared services and resources related to corporate functions such as executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations, which we refer to collectively as the "Lilly Services." Under the terms of the TSA, we will beare able to use Lilly Services for a fixed term established on a service-by-service basis. We will pay Lilly mutually
agreed-upon fees for the Lilly Services provided under the TSA, which will beare based on Lilly's cost (including third-party costs) of providing the Lilly Services through March 31, 2021, and subject to a mark-up of 7% thereafter, with additional inflation-based escalation beginning January 1, 2022. The fees under the TSA became payable for all periods beginning after October 1, 2018.
Separation Activities
Subsequent to our IPO, there continue to be transactions between us and Lilly related primarily to the completion of the local country asset purchases and finalization of assets and liabilities associated with the legal separation from Lilly, combined income tax returns and the impact of the tax matters agreement, historical Lilly retirement benefits, and centralized cash management. The net impact of these activities of $3.0 million and $28.4 million for the three and nine months ended September 30, 2019, respectively, has been reflected as Separation Activities within shareholders' equity. The most significant of these activities includes the finalization of the local country valuation of business and the resulting impact on deferred tax assets and the impact of combined tax returns.
Other Activities
We continue to share certain services and back office functions with Lilly, which in certain instances result in Lilly paying costs for Elanco (e.g., utilities, local country operating costs, etc.) that are then passed through to Elanco for reimbursement. These amounts are included in cash flows from operating activities in our condensed consolidated and combined statements of cash flows. In addition, we operate through a single treasury settlement process and prior to the local country asset purchases (as described below) continued to transact through Lilly's processes in certain instances. As a result of these activities, there were certain amounts of financing that occurred between Lilly and Elanco during the nine month periodthree months ended September 30,March 31, 2019. Further, during the three months ended March 31, 2020, our financing cash flows include a $15.2 million outflow to Lilly related to a local country asset purchase that was in addition to the original Separation plan. This amount will be reimbursed by Lilly in the second quarter of 2020. These amounts are included in cash flows from financing activities in our condensed consolidated and combined statements of cash flows.
Local Country Asset Purchases
The legal transfer of certain of our net assets did not occur prior to the Separation due to certain regulatory requirements in each of these countries. The related assets, liabilities, and results of operations have been reported in our condensed consolidated and combined financial statements, as we are responsible for the business activities conducted by Lilly on our behalf and are subject to the risks and entitled to the benefits generated by these
operations and assets under the terms of the MSA. We held restricted cash, and the associated payable to Lilly, at the date of Separation to fund the acquisition of these assets. As of September 30, 2019,March 31, 2020, the majority of these assets have been legally acquired and the remainder are expected to be purchased during 2019.2020. Restricted cash and Payable to Lilly of $11.1$10.7 million are recorded inon the condensed consolidated balance sheet for the remainder of the assets expected to be purchased by the end of 2019.2020.
Transactions with Lilly Prior to Full Separation
Prior to the IPO, we did not operate as a standalone business and had various relationships with Lilly whereby Lilly provided services to us. The impact on our historical combined financial statements includes the following:
Transfers to/from Lilly, net
As discussed in Note 2: Basis of Presentation, net parent company investment is primarily impacted by contributions from Lilly which are the result of treasury activity and net funding provided by or distributed to Lilly. For the three and nine months ended September 30, 2018, net transfers to Lilly were $116.8 million and $226.3 million, respectively. Activities that impacted the net transfers (to)/from Lilly include corporate overhead and other allocations, income taxes, retirement benefits, and centralized cash management.Stock-based Compensation
Corporate overhead and other allocations
Prior to full separation, Lilly provided us certain services, including executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations. We provide Lilly certain services related to manufacturing support. Our financial statements reflected an allocation of these costs. When specific identification is not practicable, the remainder have been allocated primarily on a proportional cost method on a basis of revenue or headcount.
The allocations of services from Lilly to us were reflected as follows in the condensed consolidated and combined statements of operations:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended September 30, | | | | Nine Months Ended September 30, | | |
| 2019 | | 2018 | | 2019 | | 2018 |
| Cost of sales | $ | — | | | $ | 7.0 | | | $ | — | | | $ | 21.8 | |
| Research and development | — | | | 0.7 | | | — | | | 2.2 | |
| Marketing, selling and administrative | — | | | 26.4 | | | — | | | 81.2 | |
| Total | $ | — | | | $ | 34.1 | | | $ | — | | | $ | 105.2 | |
We provide Lilly certain services related to manufacturing support. Allocations of manufacturing support from us to Lilly were $1.3 million and $3.7 million for the for the three and nine months ended September 30, 2018, respectively which reduced cost of sales in the unaudited condensed consolidated and combined statements of operations.
The financial information herein may not necessarily reflect our consolidated financial position, results of operations and cash flows in the future or what they would have been if we had been a separate, standalone entity during the periods presented. Management believes that the methods used to allocate expenses are reasonable.
Stock-based Compensation
Prior to full separation, our employees participated in Lilly stock-based compensation plans, the costs of which were allocated to us and recorded in cost of sales, research and development, and marketing, selling and administrative expenses in the unaudited condensed consolidated and combined statements of operations. The costs of such plans related to our employees were $5.1 million for the ninethree months ended September 30,March 31, 2019. The costs of such plans related to our employees were $6.9 million and $20.2 million for the three and nine months ended September 30, 2018, respectively.
Retirement Benefits
Prior to full separation, our employees participated in defined benefit pension and other post retirement plans sponsored by Lilly, the costs and benefits of which were recorded in the unaudited condensed consolidated and combined statement of operations in cost of sales, research and development, and marketing, selling and
administrative expenses. For the three and nine months ended September 30, 2018, the benefit of such plans related to our employees was $1.6 million and $0.3 million, respectively.
Centralized Cash Management
Lilly uses a centralized approach to cash management and financing of operations. Until Separation, the majority of our business was party to Lilly’s cash pooling arrangements to maximize Lilly's availability of cash for general operating and investing purposes. Under these cash pooling arrangements, cash balances were swept regularly from our accounts. Cash transfers to and from Lilly’s cash concentration accounts and the resulting balances at the end of each reporting period were reflected in net parent company investment in the condensed consolidated and combined statements of equity.
Debt
Lilly’s third-party debt and the related interest expense were not allocated to us for any of the periods presented as we were not the legal obligor of the debt and Lilly borrowings were not directly attributable to our business.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations
(Tables present dollars in millions, except per-share data)
The management’s
Management’s discussion and analysis of financial condition and results of operations is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operations and financial position. This discussion and analysis should be read in conjunction with the unaudited condensed consolidated and combined financial statements and accompanying footnotes in Item 1 of Part I of this Quarterly Report on Form 10-Q. Certain statements in this Item 2 of Part I of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements," Item 1A, "Risk Factors," of Part II of this Quarterly Report on Form 10-Q, and of Part II of our Quarterly Reports on Form 10-Q for the quarterly periods ended June 30, 2019 and March 31, 2019, and Item 1A, “Risk Factors,” of Part I of our Annual Report on Form 10-K for the year ended December 31, 2018,2019, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.
Overview
Founded in 1954 as part of Eli Lilly and Company (Lilly), Elanco is a premier animal health company that innovates, develops, manufactures and markets products for companion and food animals. Headquartered in Greenfield, Indiana, we are the fourth largest animal health company in the world, with revenue of $3,066.8$3,071.0 million for the year ended December 31, 2018.2019. Globally, we are #1 in medicinal feed additives, #2 in poultry, and #3 in other pharmaceuticals, which are mainly companion animal therapeutics, and #2 in poultry, measured by 2018 revenue, according to Vetnosis.
We have one of the broadest portfolios of pet parasiticides in the companion animal sector. We offer a diverse portfolio of more than 125 brands that make us a trusted partner to veterinarians and food animal producers in more than 90 countries.
On September 24, 2018, we completed our initial public offering (IPO), pursuant to which we issued and sold 19.8% of our total outstanding shares. On September 20, 2018, our common stock began trading on the New York Stock Exchange (NYSE) under the symbol “ELAN.” On September 24, 2018, immediately preceding the completion of the IPO, Lilly transferred to us substantially all of its animal health businesses in exchange for (i) all of the net proceeds (approximately $1,659.7 million) we received from the sale of our common stock in the IPO, including the net proceeds we received as a result of the exercise in full of the underwriters’ option to purchase additional shares, (ii) all of the net proceeds (approximately $2,000 million) we received from the issuance of our senior notes; and (iii) all of the net proceeds ($498.6 million) we received from the entry into our term loan facility. In addition, immediately prior to the completion of the IPO, we entered into certain agreements with Lilly that provide a framework for our ongoing relationship with them.
On February 8, 2019, Lilly announced an exchange offer whereby Lilly shareholders could exchange all or a portion of Lilly common stock for shares of Elanco common stock owned by Lilly. On that date, we filed a Registration Statement on Form S-4 with the SEC in connection with that exchange offer. The disposition of Elanco shares was completed on March 11, 2019, and resulted in the full separation of Elanco andalong with the disposal of Lilly's entire ownership and voting interest in Elanco.
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 four primary categories:
Companion Animal Disease Prevention (CA Disease Prevention): We have one of the broadest parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in the U.S. in the disease prevention category based on share of revenue.
Companion Animal Therapeutics (CA Therapeutics): We have a broad pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. Pet owners are increasingly treating osteoarthritis in their pets, and our GalliprantGalliprant™ product is one of the fastest growing osteoarthritis treatments in the U.S. We also have treatments for otitis (ear infections), as well as cardiovascular and dermatology indications.
Food Animal Future Protein & Health (FA Future Protein & Health): Our portfolio in this category, which includes vaccines, nutritional enzymes and animal-onlyanimal only antibiotics, serves the growing demand for protein and includes innovative products in poultry and aquaculture production,
where demand for animal health products is outpacing overall industry growth. We are focused on developing functional nutritional health products that promote food animal health, including enzymes, probiotics and prebiotics. We are a leader in providing vaccines as alternatives to antibiotics to promote animal health based on share of revenue.
Food Animal Ruminants & Swine (FA Ruminants & Swine): We have developed a range of food animal products used extensively in ruminant (e.g., cattle, sheep and goats) and swine production.
For the three months ended September 30,March 31, 2020 and 2019, and 2018, our revenue was $771.3$657.7 million and $761.1$731.1 million, respectively. For the three months ended September 30,March 31, 2020 and 2019, and 2018, our net (loss) income was $10.0$(49.1) million and $60.2$31.5 million, respectively.
For the nine months ended September 30, 2019 and 2018, our revenue was $2,284.0 million and $2,267.5 million, respectively. For the nine months ended September 30, 2019 and 2018, our net income was $77.4 million and $70.1 million, respectively.
Increases or decreases in inventory levels at our channel distributors can positively or negatively impact our quarterly and annual revenue results, leading to variations in quarterly revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, and procedures and environmental factors beyond our control, including weather conditions.
Key Trends and Conditions Affecting Our Results of Operations
Industry Trends
The animal health industry, which focuses onincludes both food animals and companion animals, is a growing industry that benefits billions of people worldwide.
As demand for animal protein grows, food animal health is becoming increasingly important. FactorsWe believe that factors influencing growth in demand for food animal medicines and vaccines include:
•one in three people need improved nutrition;
•increased global demand for protein, particularly poultry and aquaculture;
•natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production;
•loss of productivity due to food animal disease and death;
•increased focus on food safety and food security; and
•human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization.
Growth in food animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity.
FactorsWe believe that factors influencing growth in demand for companion animal medicines and vaccines include:
•increased pet ownership globally;
•pets living longer; and
•increased pet spending as pets are viewed as members of the family by owners.
Factors Affecting Our Results of Operations
COVID-19 Pandemic
The recent outbreak of COVID-19 originating in Wuhan, China, in December 2019 has since rapidly increased its exposure globally. On March 11, 2020, the World Health Organization declared the outbreak a pandemic. We are monitoring the global outbreak of COVID-19 and are working with our customers, employees, suppliers and other stakeholders to mitigate the risks posed by its spread. The COVID-19 pandemic is affecting the economy in the United States and globally, and has affected the operations of our company, vendors and suppliers, supply of and demand for our products, and our liquidity as follows:
Operations
As a result of the COVID-19 pandemic, governmental authorities have implemented and are continuing to implement numerous and constantly evolving measures to try to contain the virus, such as travel bans and restrictions, limits on gatherings, quarantines, shelter-in-place orders, site closures and business shutdowns. These measures have impacted the ability of our employees, vendors, and suppliers to perform their respective responsibilities and obligations relative to the conduct of our business. We have important manufacturing operations worldwide that have been affected by the outbreak. Measures requiring business shutdowns generally exclude certain essential services, and those essential services commonly include critical infrastructure and the businesses that support that critical infrastructure. Because the animal health industry has been designated an essential business, our manufacturing and research facilities remain operational, while our employees in other company functions are working remotely. These measures have impacted and may further impact our workforce and operations, as well as those of our customers, vendors and suppliers.
Supply
We have not yet experienced any significant impacts or interruptions to our supply chain as a result of the COVID-19 pandemic. However, our suppliers may face difficulties maintaining operations in light of government-ordered restrictions and shelter-in-place mandates. Although we regularly monitor the financial health of companies in our supply chain, the financial hardship on our suppliers caused by the COVID-19 pandemic could cause a disruption in our ability to obtain raw materials or components required to manufacture our products, adversely affecting our operations. Freight processes relating to the shipment of our finished goods have also been disrupted and have started to result in higher shipping costs, which has negatively impacted our profitability.
Demand
The COVID-19 pandemic has adversely impacted global economic conditions. In particular, the COVID-19 pandemic has created near-term uncertainty for our channel distribution partners with respect to end customer demand and working capital. Based on these factors, in addition to a shift in tactics for demand generation with our distributors, we reduced the amount of inventory held in the channel. We anticipate that these decreases in end customer demand may impact our companion animal business, primarily in vaccines and international markets, as social distancing guidelines have decreased veterinary visits, reduced veterinary practice revenue and increased working capital considerations for all parties in our value chain. In our food animal business, demand is expected to be negatively impacted by processing plant closures and pressured producer economics, as well as an effort by dairy farmers to decrease milk production, which could impact demand for a number of our food animal products. We anticipate that decreases in demand will occur, though the extent to which our operations may be impacted by the COVID-19 pandemic will depend largely on future developments, which are highly uncertain and cannot be accurately predicted at this time.
Liquidity
Our third party distributors may face difficulties maintaining operations and normal liquidity in light of government-mandated restrictions. Due to liquidity and working capital pressure caused by the COVID-19 pandemic, our distributors are managing inventory more tightly. In response to this along with a shift in tactics for demand generation with our distributors, we decided to reduce channel inventory levels during the quarter as we tighten our approach across all facets of our distributor relationships. We expect to take similar actions going forward. These actions will allow us to improve working capital management, implement new compensation structures with our distributors and enable greater control of overall stock levels. We estimate the impact on revenues to have been
approximately $60 million through March 31, 2020, with another $80 million to $100 million of potential impact, primarily in the second quarter of 2020, as we expand this practice across our business and geographies. We continue to monitor the impacts on our customers' liquidity and therefore our ability to collect on our accounts receivable. While our allowance on these receivables factors in expected credit losses, continued disruption and declines in the global economy could result in difficulties in our ability to collect and thus require increases in our allowance for doubtful accounts.
Product Development and New Product Launches
A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation, primarily in our three targeted growth categories of CA Disease Prevention, CA Therapeutics and FA Future Protein & Health. Since 2015, we'vewe have launched or acquired 14 new products, fiveincluding the additions of which were launchedEntyce™, Nocita™ and Tanovea™ in 20172019 through acquisition and 2018.business development activities. Revenue from these products contributed $325.0$92.4 million to revenue for the ninethree months ended September 30, 2019.March 31, 2020. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depends on both our pipeline of new products, including
new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization.
Productivity
Our results during the periods presented have benefited from our continued operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds.
Our acquisitions within the last six years added in the aggregate $1.4 billion in revenue, 4,600 full-time employees, 12 manufacturing and eight R&D sites. In addition, from 2015 to 2019, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation. Weinnovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across the manufacturing, R&D and marketing, selling, general and administrative functions, such as rationalization of stock keeping units, reduction of contract(SG&A) functions. Our manufacturing organizations, implementation ofcost savings strategies included improving manufacturing processes and headcount through lean manufacturing principles(minimizing waste while maintaining productivity), closing of three manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities with respect to raw materials via a new procurement initiatives.process. Additional cost savings resulted from reducing the number of R&D sites from 16 to nine, SG&A savings from sales force consolidation, and reducing discretionary and other general and administrative (G&A) operating expense.
Foreign Exchange Rates
Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. During the ninethree months ended September 30,March 31, 2020 and 2019, approximately 49% and 2018, approximately 43% and 51%42%, respectively, of our revenue was denominated in foreign currencies. As we operate in multiple foreign currencies, including the Euro, British pound, Swiss franc, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements decreased revenue by 2%1% during the ninethree months ended September 30, 2019.March 31, 2020. Currency movements had limited impact on revenue during the ninethree months ended September 30, 2018.March 31, 2019.
Our Relationship with Lilly and Additional Standalone Costs
During the period prior to the IPO, our business operated solely as part of a division of Lilly. Our combined financial statements have been derived from Lilly’s consolidated financial statements and accounting records. Our combined financial statements reflect the financial position, results of operations and cash flows of the business that was transferred at the time of the Separation and do not purport to reflect what the results of operations, comprehensive income/(loss), financial position, equity or cash flows would have been had we operated as an independent, publicly traded company during the periods presented prior to the IPO.
Our historical results reflect an allocation of costs for certain Lilly corporate costs for periods prior to the IPO, including, among others, executive oversight, treasury, legal, finance, human resources, tax, internal audit, financial reporting, information technology and investor relations. These allocations are not necessarily indicative of the expenses we may incur as a standalone public company. Although we entered into certain agreements with Lilly in connection with the IPO and the Separation, the amount and composition of our expenses may vary from historical levels since the fees charged for the services under these agreements may be higher or lower than the costs reflected in the historical allocations. The total allocations included in our results for the three months ended September 30, 2019 and September 30, 2018 were $0.0 million and $34.1 million, respectively. The total allocations included in our results for the nine months endedSeptember 30, 2019 and September 30, 2018 were $0.0 million and $105.2 million, respectively. See Note 17: Related Party Agreements and Transactions in our unaudited condensed consolidated and combined financial statements.
We are currently investing in expanding our own administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by Lilly. Because of initial stand up costs and overlaps with services previously provided by Lilly, we have incurred and expect to continue to incur certain temporary, duplicative expenses in connection with the Separation. We have also incurred and expect to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics, among others. We currently estimate these costs taken together to be in a range from $240 million to $290 million, net of potential real estate dispositions and employee benefit
changes, of which a portion will be capitalized and the remainder will be expensed.
Lilly utilizes a centralized treasury management system, of which we were a part until our IPO. For periods prior to the IPO, our condensed consolidated and combined financial statements reflect cash held only in bank accounts in our legal name and no allocation of combined cash positions. Our unaudited condensed consolidated and combined financial statements do not reflect an allocation of Lilly’s debt or any associated interest expense.
In connection with the IPO, we incurred $2.5 billion of long-term borrowings. Our historical results reflect $29.6 million of interest expense during the year ended December 31, 2018 due to the timing of the borrowings, in comparison to $18.7 million and $60.2 million for the three and nine months ended September 30, 2019, respectively. We have estimated
interest expense of approximately $85$99 million on an annual basis based on our borrowings as of September 30, 2019.March 31, 2020.
For the periods prior to the IPO, our condensed consolidated and combined financial statements reflect income tax expense (benefit) computed on a separate company basis, as if operating as a standalone entity or a separate consolidated group in each material jurisdiction in which we operate. Our condensed consolidated and combined financial statements for the periods prior to the IPO also reflect certain deferred tax assets and liabilities and income taxes payable based on this approach that did not transfer to us upon the Separation, as the underlying tax attributes were used by Lilly or retained by Lilly. As a result of potential changes to our business model and the fact that certain deferred tax assets and liabilities and income taxes payable did not transfer to us, income tax expense (benefit) included in the condensed consolidated and combined financial statements may not be indicative of our future expected tax rate.
Our historical results prior to IPO also do not reflect the impact of costs we have incurred and expect to continue to incur as a consequence of becoming a standalone company, including incremental costs associated with being a publicly traded company.
We are instituting competitive compensation policies and programs as a standalone public company, the expense for which may differ from the compensation expense allocated by Lilly in our condensed consolidated and combined financial statements.
As a result of the IPO, we became subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, and the Sarbanes-Oxley Act. We are establishing or expandingcontinue to establish and expand additional procedures and practices as a standalone public company. As a result, we will continue to incur additional costs as a standalone public company compared to the prior period, including internal audit, external audit, investor relations, stock administration, stock exchange fees and regulatory compliance costs.
Asset Impairment, Restructuring and Other Special Charges
Our results have been impacted by asset impairment, restructuring and other special charges, including integration of acquired businesses, during the ninethree months ended September 30, 2019March 31, 2020 and 2018.2019. These charges primarily include severance costs resulting from actions taken to reduce our cost structure, asset impairment charges related to product rationalization and site closures, and charges and costs related to our integration efforts as a result of our acquired businesses and the pending acquisition of Bayer's animal health business, external costs directly related to acquiring businesses, including expenses for banking, legal, accounting, and other similar services, and costs to stand our organization up to be an independent company.
For more information on these charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges in our condensed consolidated and combined financial statements.
Results of Operations
The following discussion and analysis of our results of operations should be read along with our condensed consolidated and combined financial statements and the notes thereto.
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | % Change | | 2019 | | 2018 | | % Change | | | | 2020 | | 2019 | | % Change |
| Revenue | Revenue | $ | 771.3 | | | $ | 761.1 | | | 1 | % | | $ | 2,284.0 | | | $ | 2,267.5 | | | 1 | % | Revenue | | | $ | 657.7 | | | $ | 731.1 | | | (10) | % |
| Costs, expenses and other: | Costs, expenses and other: | | Costs, expenses and other: | | |
| Cost of sales | Cost of sales | 360.4 | | | 369.8 | | | (3) | % | | 1,060.2 | | | 1,161.3 | | | (9) | % | Cost of sales | | | 332.7 | | | 343.8 | | | (3) | % |
| % of revenue | % of revenue | 47 | % | | 49 | % | | (2) | % | | 46 | % | | 51 | % | | (5) | % | % of revenue | | | 51 | % | | 47 | % | | 4 | % |
| Research and development | Research and development | 69.9 | | | 58.9 | | | 19 | % | | 202.8 | | | 185.5 | | | 9 | % | Research and development | | | 66.8 | | | 64.1 | | | 4 | % |
| % of revenue | % of revenue | 9 | % | | 8 | % | | 1 | % | | 9 | % | | 9 | % | | — | % | % of revenue | | | 10 | % | | 9 | % | | 1 | % |
| Marketing, selling and administrative | Marketing, selling and administrative | 192.3 | | | 179.0 | | | 7 | % | | 574.3 | | | 550.1 | | | 4 | % | Marketing, selling and administrative | | | 182.0 | | | 181.1 | | | — | % |
| % of revenue | % of revenue | 25 | % | | 24 | % | | 1 | % | | 25 | % | | 24 | % | | 1 | % | % of revenue | | | 28 | % | | 25 | % | | 3 | % |
| Amortization of intangible assets | Amortization of intangible assets | 50.7 | | | 48.7 | | | 4 | % | | 149.0 | | | 147.3 | | | 1 | % | Amortization of intangible assets | | | 51.6 | | | 49.0 | | | 5 | % |
| % of revenue | % of revenue | 7 | % | | 6 | % | | — | % | | 7 | % | | 6 | % | | — | % | % of revenue | | | 8 | % | | 7 | % | | 1 | % |
| Asset impairment, restructuring and other special charges | Asset impairment, restructuring and other special charges | 77.2 | | | 12.4 | | | 523 | % | | 133.9 | | | 82.8 | | | 62 | % | Asset impairment, restructuring and other special charges | | | 74.8 | | | 24.9 | | | 200 | % |
| Interest expense, net of capitalized interest | Interest expense, net of capitalized interest | 18.7 | | | 8.6 | | | 117 | % | | 60.2 | | | 8.6 | | | 600 | % | Interest expense, net of capitalized interest | | | 16.5 | | | 20.8 | | | (21) | % |
| Other - net, expense | Other - net, expense | 14.6 | | | 4.9 | | | NM | | | 21.1 | | | 15.6 | | | NM | | Other - net, expense | | | 1.1 | | | 2.6 | | | (58) | % |
| Income (loss) before taxes | (12.5) | | | 78.8 | | | NM | | | 82.5 | | | 116.3 | | | NM | | |
| Income (loss) before income taxes | | Income (loss) before income taxes | | | (67.8) | | | 44.8 | | | NM | |
| % of revenue | % of revenue | (2) | % | | 10 | % | | (12) | % | | 4 | % | | 5 | % | | 4 | % | % of revenue | | | (10) | % | | 6 | % | | NM | |
| | Income tax (benefit) expense | Income tax (benefit) expense | (22.5) | | | 18.6 | | | (221) | % | | 5.1 | | | 46.2 | | | (89) | % | Income tax (benefit) expense | | | (18.7) | | | 13.3 | | | (241) | % |
| Net income | $ | 10.0 | | | $ | 60.2 | | | NM | | | $ | 77.4 | | | $ | 70.1 | | | NM | | |
| Net income (loss) | | Net income (loss) | | | $ | (49.1) | | | $ | 31.5 | | | (256) | % |
Certain amounts and percentages may reflect rounding adjustments.
NM - Not meaningful
Revenue
On a global basis, our revenue within our product categories was as follows:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | | | | Three Months Ended March 31, | |
| | 2019 | | 2018 | | % Change | | 2019 | | 2018 | | % Change | | | | 2020 | | 2019 | | % Change |
| CA Disease Prevention | CA Disease Prevention | $ | 207.6 | | | $ | 188.6 | | | 10 | % | | $ | 616.9 | | | $ | 603.9 | | | 2 | % | CA Disease Prevention | | | $ | 140.3 | | | $ | 185.9 | | | (25) | % |
| CA Therapeutics | CA Therapeutics | 87.6 | | | 80.5 | | | 9 | % | | 252.4 | | | 211.1 | | | 20 | % | CA Therapeutics | | | 65.8 | | | 81.4 | | | (19) | % |
| FA Future Protein & Health | FA Future Protein & Health | 191.5 | | | 162.8 | | | 18 | % | | 534.5 | | | 502.1 | | | 6 | % | FA Future Protein & Health | | | 180.0 | | | 167.2 | | | 8 | % |
| FA Ruminants & Swine | FA Ruminants & Swine | 266.2 | | | 301.5 | | | (12) | % | | 811.8 | | | 881.1 | | | (8) | % | FA Ruminants & Swine | | | 252.6 | | | 274.1 | | | (8) | % |
| Subtotal | Subtotal | 752.9 | | | 733.4 | | | 3 | % | | 2,215.6 | | | 2,198.2 | | | 1 | % | Subtotal | | | 638.7 | | | 708.6 | | | (10) | % |
Strategic Exits(1) | Strategic Exits(1) | 18.4 | | | 27.7 | | | (34) | % | | 68.4 | | | 69.3 | | | (1) | % | Strategic Exits(1) | | | 19.0 | | | 22.5 | | | (16) | % |
| Total | Total | $ | 771.3 | | | $ | 761.1 | | | 1 | % | | $ | 2,284.0 | | | $ | 2,267.5 | | | 1 | % | Total | | | $ | 657.7 | | | $ | 731.1 | | | (10) | % |
(1)Represents revenue from business activities we have either exited or made a strategic decision to exit.
Total revenue
Three months ended September 30, 2019March 31, 2020 vs. three months ended September 30, 2018March 31, 2019
Total revenue increased $10.2decreased $73.4 million or 1%10% for the three months ended September 30, 2019March 31, 2020 as compared to the three months ended September 30, 2018,March 31, 2019, reflecting a 4% increase in price, partially offset by a 1%10% decrease in volume and a 1% unfavorable impact from foreign exchange rates.rates, partially offset by a 1% increase in price.
In summary, the total revenue increasedecrease was due primarily to:
•an increasea decrease in revenue of $20.6$44.3 million or 11%24% from CA Disease Prevention products, excluding the impact of foreign exchange rates;
•an increasea decrease in revenue of $8.0$14.7 million or 10%18% from CA Therapeutics products, excluding the impact of foreign exchange rates;
•an increase in revenue of $32.4 million or 20% from FA Future Protein & Health products, excluding the impact of foreign exchange rates; and
partially offset by:
•a decrease in revenue of $33.3$18.8 million or 11%7% from FA Ruminants & Swine products, excluding the impact of foreign exchange rates;
•a decrease in revenue of $9.2$3.0 million or 33% from Strategic Exits, excluding the impact of foreign exchange rates.
•a decrease in revenue of $8.3 million due to the negative impact of foreign exchange rates.
The detailed change in revenue by product category was as follows:
•CA Disease Prevention revenue increased by $19.0 million or 10% for the quarter, driven by both increased volume and price, partially offset by an unfavorable impact from foreign exchange rates. The revenue increase was primarily driven by continued increases in sales of Interceptor Plus® and Credelio®, vaccines, and initial stocking for a new customer agreement.
•CA Therapeutics revenue increased by $7.1 million or 9% for the quarter, driven by increased volume and to a lesser extent price, partially offset by the unfavorable impact of foreign exchange rates. The revenue increase was driven by increased demand for products across the therapeutics portfolio, primarily Galliprant, initial stocking for a new customer agreement, and sales of Entyce® and Nocita® resulting from the third quarter acquisition of Aratana.
•FA Future Protein & Health revenue increased by $28.7 million or 18% for the quarter, driven by both increased volume and price, partially offset by an unfavorable impact from foreign exchange rates. Growth was driven primarily by the aqua and poultry portfolios. In addition, third quarter revenue was positively impacted by one-time items including the sale of the remaining inventory of a product that is being phased out in China as well as purchasing patterns in the prior year that created a favorable comparison for poultry products.
•FA Ruminants & Swine revenue decreased by $35.3 million or 12% for the quarter, driven by a decline in volume and to a lesser extent an unfavorable impact from foreign exchange rates, partially offset by an increase in price. The decline in revenue was driven by softness in swine products due to African Swine Fever across Asia, a disruption in global supply of certain third-party produced injectable cattle products, reduced U.S. producer use of Paylean, changes in distributor purchasing for Rumensin as anticipated, and the impact from the Australian drought, partially offset by revenue generated from Posilac sales as a result of the revised commercial agreement entered into in the third quarter of 2019.
•Strategic Exits revenue decreased by $9.3 million to $18.4 million and represented 2% of total revenue.
Nine months endedSeptember 30, 2019 vs. nine months ended September 30, 2018
Total revenue increased $16.5 million or 1% for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018, reflecting a 1% increase due to higher volumes and an increase of 2% due to price, offset by a 2% unfavorable foreign exchange rate.
In summary, the total revenue increase was due primarily to:
•an increase in revenue of $21.0 million or 3% from CA Disease Prevention products, excluding the impact of foreign exchange rates;
•an increase in revenue of $47.1 million or 22% from CA Therapeutics products, excluding the impact of foreign exchange rates;
•an increase in revenue of $54.0 million or 11% from FA Future Protein & Health products, excluding the impact of foreign exchange rates; and
partially offset by:
•a decrease in revenue of $53.2 million or 6% from FA Ruminants & Swine products, excluding the impact of foreign exchange rates;
•a decrease in revenue of $0.8 million or 1%13% from Strategic Exits, excluding the impact of foreign exchange rates; and
•a decrease in revenue of $51.6$9.5 million due to the negative impact of foreign exchange rates.
partially offset by:
•an increase in revenue of $16.9 million or 10% from FA Future Protein & Health products, excluding the impact of foreign exchange rates.
The detailed change in revenue by product category was as follows:
•CA Disease Prevention revenue increaseddecreased by $13.0$45.6 million or 2%, primarily25% for the quarter, driven by decreased volume and to a lesser extent an unfavorable impact from foreign exchange rates, offset by an increase in price andprice. The volume decrease was the result of actions across brands to reduce channel inventory levels due to the impact of the COVID-19 pandemic on the companion animal market. While underlying end user demand for certain products grew in the first quarter, we took actions to reduce channel inventory levels due to the impact of the COVID-19 pandemic on the companion animal market. The decrease in revenue resulting from these actions was partially offset by an increase in direct sales, particularly in alternative channels outside vet clinics.
•CA Therapeutics revenue decreased by $15.6 million or 19% for the quarter, driven by decreased volume and to a lesser extent an unfavorable impact from foreign exchange rates. Continued growthWhile clinic-level demand for Galliprant grew in Credeliomajor markets and Interceptor Plus and an increasegeographic expansion continued into Latin
America in revenuethe first quarter, the volume decrease was the result of actions taken across brands to reduce channel inventory levels due to initial stocking for a new customer agreement were partially offset by declines in salesthe impact of certain older generation parasiticides and vaccines.
•CA Therapeutics revenue increased by $41.3 million or 20%, driven by increased volume and to a lesser extent price,the COVID-19 pandemic on the companion animal market, partially offset by the impactinclusion of foreign exchange rates. The revenue increase was driven by increased demandsales for products across the therapeutics portfolio, primarily Galliprant, initial stocking for a new customer agreement,Entyce and sales of Entyceand Nocita as a result of the acquisition of Aratana.Aratana in the third quarter of 2019 and an increase in direct sales, particularly in alternative channels outside vet clinics.
•FA Future Protein & Health revenue increased by $32.4$12.8 million or 6%,8% for the quarter, driven by both increased volume and price, partially offset by an unfavorable impact from foreign exchange rates. Growth was driven by strong demand in the international poultry and aqua portfolio. Inportfolios, in addition thirdto anticipatory buying in the first quarter by direct customers in international export markets to ensure continuity of supply ahead of potential COVID-19 pandemic disruptions.
•FA Ruminants & Swine revenue was positively impacteddecreased by one-time items including$21.5 million or 8% for the salequarter, driven by decreased volume, price, and an unfavorable impact from foreign exchange rates. The decrease is driven by actions to reduce inventory levels across brands due to the impact of the remaining inventory of a product that is being phased out in ChinaCOVID-19 pandemic, as well as favorable purchasing patterns in the priorfirst quarter of 2019 for Rumensin and producer removal of Paylean™ to access export markets, and the continued replenishment of sterile injectable products from our contract manufacturing partner. These decreases were partially offset by increased demand in the China swine market as a result of favorable producer economics and positive efforts to repopulate herds impacted by African Swine Fever in 2019, in addition to anticipatory buying in the quarter by direct customers in international export markets to ensure continuity of supply ahead of potential COVID-19 pandemic disruptions.
•Strategic Exits revenue decreased by $3.5 million to $19.0 million and represented 3% of total revenue.
Costs and Expenses and Other
Cost of sales
Three months ended March 31, 2020 vs. three months ended March 31, 2019
Cost of sales decreased $11.1 million in the three months ended March 31, 2020 as compared to the three months ended March 31, 2019 due primarily to manufacturing productivity improvements and decreased revenue.
Cost of sales as a percent of revenues increased to 50.6% for the three months ended March 31, 2020 from 47.0% for the three months ended March 31, 2019, primarily due to unfavorable product and geographic mix and an unfavorable effect of foreign exchange rates on international inventories sold, partially offset by decreases in cost of sales discussed above.
Research and development
Three months ended March 31, 2020 vs. three months ended March 31, 2019
R&D expenses increased $2.7 million for the three months ended March 31, 2020 as compared to the three months ended March 31, 2019, primarily due to additional costs from acquired businesses in 2019, including Aratana and Prevtec.
Marketing, selling and administrative
Three months ended March 31, 2020 vs. three months ended March 31, 2019
Marketing, selling and administrative expenses increased $0.9 million for the three months ended March 31, 2020 as compared to the three months ended March 31, 2019 due to additional costs from acquired businesses during the year, that created a favorable comparison for poultry products.primarily Aratana, partially offset by strong expense management.
•FA Ruminants & Swine revenue decreased by $69.3 million or 8% driven by a decline in volume and to a lesser extent the unfavorable impactAmortization of foreign exchange rates, partially offset by a minor increase in price. The decline in revenue was driven by softness in swine products due to African Swine Fever across Asia, a disruption in global supply of certain third-party produced injectable cattle products, reduced U.S. producer use of Paylean, changes in distributor purchasing for Rumensin as anticipated, and the impact from the Australian drought. These decreases were partially offset by revenue generated from Posilacsales as a result of the revised commercial agreement entered into in the third quarter of 2019 and favorable purchasing patterns for certain cattle products, primarily Optaflexx.intangible assets
•
Strategic Exits revenue decreased by $0.9 million to $68.4 million and represented 3% of total revenue.
Costs and Expenses and Other
Cost of sales
Three months ended September 30, 2019March 31, 2020 vs. three months ended September 30, 2018March 31, 2019
Cost
Amortization of sales decreased $9.4intangible assets increased $2.6 million infor the three months ended September 30, 2019March 31, 2020 as compared to the three months ended September 30, 2018 due primarily to manufacturing productivity improvements.
Nine months ended September 30,March 31, 2019, vs. nine months ended September 30, 2018
Cost of sales decreased $101.1 million in the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018 due primarily to manufacturing productivity improvements and charges recorded during the nine months ended September 30, 2018 for inventory adjustments related to the suspension of commercial activities of Imrestor and the closure of the Larchwood, Iowa facility, partially offset by unfavorable product mix and logistics costs.
Research and development
Three months ended September 30, 2019 vs. three months ended September 30, 2018
R&D expenses increased $11.0 million for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018, primarily due to additional costs from acquired businesses during the period, increased costs from R&D infrastructure investments, and project spend as a result of pipeline progression.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
R&D expenses increased $17.3 million for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018 primarily due to additional costs from acquired businesses during the year, increased costs from R&D infrastructure investments, project spend as a result of pipeline progression, and increased costs as a result of operating as a standalone company during the nine months ended September 30, 2019.
Marketing, selling and administrative
Three months ended September 30, 2019 vs. three months ended September 30, 2018
Marketing, selling and administrative expenses increased $13.3 million for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018 due to additional costs from acquired businesses during the year, primarily Aratana, increased marketing efforts for our companion animal portfolio, and increased expenses as a result of operating as a standalone company.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Marketing, selling and administrative expenses increased $24.2 million for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018 due primarily to additional costs from acquired businesses during the year, primarily Aratana, increased marketing efforts for our companion animal portfolio, and increased expenses as a result of operating as a standalone company, partially offset by slightly lower selling costs and lower costs due to continued productivity initiatives and cost control measures across the business.
Amortization of intangible assets
Three months ended September 30, 2019 vs. three months ended September 30, 2018
Amortization of intangible assets increased $2.0 million for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018, primarily due to the addition of amortization of intangible assets recorded from the acquisitions of Aratana and Prevtec during the three months ended September 30, 2019.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Amortization of intangible assets increased $1.7 million for the nine months ended September 30, 2019 as
compared to the nine months ended September 30, 2018 primarily due to the addition of amortization of intangible assets recorded from the acquisitions of Aratana and Prevtec during the three months ended September 30, 2019.
Asset impairment, restructuring and other special charges
For additional information regarding our asset impairment, restructuring and other special charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to our condensed consolidated and combined financial statements.
Three months ended September 30, 2019March 31, 2020 vs. three months ended September 30, 2018March 31, 2019
Asset impairment, restructuring and other special charges increased $64.8$49.9 million to $77.2$74.8 million for the three months ended September 30, 2019March 31, 2020 from $12.4$24.9 million for the three months ended September 30, 2018March 31, 2019 primarily due to higher transaction costs directly related to business acquisitions, andincluding the pending acquisition of the animal health business of Bayer, higher integration costs of acquisitions, and costs associated with the implementation of new systems, programs, and processes due to the Separation from Lilly as well as severance costs, exit costs, impairment charges, and write-down charges recordedin anticipation of the acquisition of the animal health business of Bayer during the three months ended September 30, 2019,March 31, 2020, as more fully described in Note 7.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Asset impairment, restructuring and other special charges increased $51.1 million to $133.9 million for the nine months ended September 30, 2019 from $82.8 million for the nine months ended September 30, 2018 primarily due to higher transaction costs directly related to business acquisitions and higher integration costs associated with the implementation of new systems, programs, and processes due to the Separation from Lilly as well as severance costs, exit costs, impairment charges, and write-down charges recorded during the nine months ended September 30, 2019, as more fully described in Note 7.
Interest expense, net of capitalized interest
Three months ended September 30, 2019March 31, 2020 vs. three months ended September 30, 2018March 31, 2019
Interest expense, net of capitalized interest, increased $10.1decreased $4.3 million from $8.6$20.8 million for the three months ended September 30, 2018March 31, 2019 to $18.7$16.5 million for the three months ended September 30, 2019. A full quarterMarch 31, 2020 primarily as a result of interest expense was recordedthe repayment of indebtedness outstanding under our existing term loan facility during the three months ended September 30, 2019, while less than one month of interest expense was recorded during the three months ended September 30, 2018 based on the timing of the issuance of debt.March 31, 2020.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Interest expense, net of capitalized interest, increased $51.6 million from $8.6 million for the nine months ended September 30, 2018 to $60.2 million for the nine months ended September 30, 2019 due to the timing of the issuance of debt during the three months ended September 30, 2018.
Other - net, expense
Three months ended September 30, 2019March 31, 2020 vs. three months ended September 30, 2018March 31, 2019
Other - net, expense increased $9.7decreased $1.5 million from $4.9$2.6 million for the three months ended September 30, 2018March 31, 2019 to $14.6$1.1 million for the three months ended September 30, 2019. Other - net,March 31, 2020.
Income tax expense during the
Three months ended March 31, 2020 vs. three months ended September 30,March 31, 2019 is primarily comprised of $8.3 million of
Income tax expense recorded due to the release of a tax indemnity related to the 2015 acquisition of Novartis and the $7.5 million increase in the value of contingent consideration liabilities recorded for Galliprant that were settled upon the closing of our acquisition of Aratana during the quarter.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Other - net, expense increased $5.5 million from $15.6 million for the nine months ended September 30, 2018 to $21.1decreased $32.0 million for the three months ended September 30, 2019. Other - net, expense during the three months ended September 30, 2019 is primarily comprised of $8.3 million of expense recorded due to the release of a tax indemnity related to the 2015 acquisition of Novartis and $13.0 million of adjustments to the contingent consideration liabilities recorded for Galliprant during the nine months ended September 30, 2019.
Income tax expense
Three months ended September 30, 2019 vs. three months ended September 30, 2018
Income tax expense decreased $41.1 million for the three months ended September 30, 2019March 31, 2020 as compared to the three months ended September 30, 2018. The decrease isMarch 31, 2019 primarily attributabledue to lower pre-tax earnings largely due to restructuring charges,driven mainly by a decrease in addition to the release of tax reserves related to final resolution of the Brazilian tax
matter.
Nine months ended September 30, 2019 vs. nine months ended September 30, 2018
Income tax expense decreased $41.1 million for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. The decrease is primarily attributable to lower pre-tax earnings largely due to restructuring charges, in addition to the release of tax reserves related to final resolution of the Brazilian tax matter.
revenue and increased acquisition and integration costs. See Note 12: Income Taxes to our condensed consolidated and combined financial statements.
Liquidity and Capital Resources
Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our Credit Facilities.credit facilities. As a significant portion of our business is conducted outside the U.S., we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. As our structure evolves as a standalone company, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.
Our principal liquidity needs going forward, in addition to funds needed for the completion of the Bayer acquisition, include funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, interest expensepayments and an anticipated dividend.payments on our amortizing notes. We believe our cash and cash equivalents on
hand, our operating cash flows and our existing financing arrangements will be sufficient to support our cash needs for the foreseeable future, including for at least the next 12 months.
Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See Forward-Looking StatementsItem 1A, "Risk Factors" for furthermore information.
Cash Flows
The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented:
| | | Nine Months Ended September 30, | | | % | | Three Months Ended March 31, | | | $ |
| Net cash provided by (used for): | Net cash provided by (used for): | 2019 | | 2018 | | Change | Net cash provided by (used for): | 2020 | | 2019 | | Change |
| Operating activities | Operating activities | $ | 97.8 | | | $ | 347.8 | | | (72) | % | Operating activities | $ | 4.3 | | | $ | 8.1 | | | $ | (3.8) | |
| Investing activities | Investing activities | (160.5) | | | (78.9) | | | 103 | % | Investing activities | (19.6) | | | (31.0) | | | 11.4 | |
| Financing activities | Financing activities | (298.6) | | | 327.2 | | | (191) | % | Financing activities | 896.6 | | | (339.5) | | | 1,236.1 | |
| Effect of exchange-rate changes on cash and cash equivalents | Effect of exchange-rate changes on cash and cash equivalents | 4.1 | | | 15.4 | | | (73) | % | Effect of exchange-rate changes on cash and cash equivalents | (9.3) | | | (14.5) | | | 5.2 | |
| Net increase (decrease) in cash, cash equivalents and restricted cash | Net increase (decrease) in cash, cash equivalents and restricted cash | $ | (357.2) | | | $ | 611.5 | | | (158) | % | Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 872.0 | | | $ | (376.9) | | | $ | 1,248.9 | |
Operating activities
Our cash provided by operating activities decreased by $250.0$3.8 million, from $347.8$8.1 million for the ninethree months ended September 30, 2018March 31, 2019 to $97.8$4.3 million for the ninethree months ended September 30, 2019.March 31, 2020. The decrease in operating cash flows was primarily attributable to increasesa decrease in accounts receivable, inventories and other assetsnet income during the period as well as the change in deferred taxes. These decreases were partially offset by a decrease in othercash used as a result of changes in operating assets and liabilities. The COVID-19 global health pandemic and related economic downturn have led to an increase in customer accounts receivable that are past due. We have extended our payment terms in the past in certain customer situations and may need to continue this practice going forward as a result of the COVID-19 global health pandemic, competitive pressures and the need for certain inventory levels at our channel distributors to avoid supply disruptions. Further extensions of customer payment terms could result in additional uses of our cash flow. The impact of these items was partially offset by an increase in net income.
Investing activities
Our cash used for investing activities increaseddecreased by $81.6$11.4 million, to $160.5$19.6 million for the ninethree months ended September 30, 2019March 31, 2020 compared to $78.9$31.0 million for the ninethree months ended September 30, 2018.March 31, 2019. The change was primarily driven by cash paid forproceeds from the acquisitionsettlement of Prevtec during the nine months ended September 30, 2019net investment hedge of $25.2 million and
an increase a decrease in cash used for other investing activities, net primarily duepurchases of property and equipment as compared to prior year, partially offset by an increase in purchases of software from 20182019 to 2019.2020.
Financing activities
Our cash provided by financing activities was $896.6 million for the three months ended March 31, 2020 as compared to cash used for financing activities was $298.6of $339.5 million for the ninethree months ended September 30, 2019 as compared to cash provided by financing activities of $327.2 million for the nine months ended September 30, 2018.March 31, 2019. Cash provided by financing activities during the ninethree months ended September 30, 2018March 31, 2020 reflects proceeds from issuances of common stock and TEUs during the period, partially offset by the repayment of indebtedness outstanding under our existing term loan facility. Cash used for financing activities during the three months ended March 31, 2019, reflected the impact of our IPO and the issuance of long-term debt in connection with our Separation from Lilly during the period. $4.2 billion of cash was generated from those transactions, which was partially offset by $3.6 billion of payments to Lilly in connection with local country asset purchases and other financing activities related to the Separation. During the nine months ended September 30, 2019, we have made $115.0 million of payments on our term credit facility as well as $191.6$331.5 million of payments to Lilly in connection with local country asset purchases and other financing activities related to the Separation.
Description of Indebtedness
For a complete description of our outstanding debt as of September 30, 2019March 31, 2020 and December 31, 2018,2019, see Note 910: Debt to our condensed consolidated and combined financial statements.
Off Balance Sheet Arrangements
In connection with our pending acquisition of the animal health business of Bayer as discussed in Note 6: Acquisitions and Divestitures, in August 2019, we entered into a commitment letter that provides for financing consisting of up to $750 million in a revolving facility, $3.0 billion in a term facility, and $2.75 billion in a senior secured bridge facility. The revolving facility, term facility, and bridge facility are subject to customary terms, conditions, and financial covenants. If drawn upon, the proceeds will be used to fund a portion of the cash to be paid in the pending acquisition of the animal health business of Bayer and the payment of related fees and expenses. The revolving facility will mature five years after the closing date of the acquisition and the term facility and bridge facility will mature seven years after the closing date of the acquisition. In connection with the financing commitment letter, we will incur fixed commitment fees of $40.4 million that will become due and payable upon the closing of the pending acquisition or the termination of the acquisition agreementPurchase Agreement with Bayer. These fees have not been recorded on the condensed consolidated balance sheet as of September 30, 2019.March 31, 2020. As a result of the financing secured for the acquisition through the equity and debt activity during the three months ended March 31, 2020, we no longer intend to use the full financing pursuant to the commitment letter. See Note 9: Equity and Note 10: Debt for more information.
Critical Accounting Policies
The preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. There are certain of our accounting policies that are considered critical, as these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments, often employing the use of estimates about the effects of matters that are inherently uncertain. Such policies are summarized in Item 7, "Management's Discussion & Analysis of Results of Financial Condition and Results of Operations," of our Annual Report on Form 10-K for the year ended December 31, 2018.2019. There have been no significant changes in the application of our critical accounting policies during the ninethree months ended September 30, 2019, aside from our adoption of ASC 842, Leases, on January 1, 2019. See Note 11: Leases in our condensed consolidated and combined financial statements for further information.
Contractual Obligations
Contractual Obligations
See Contractual Obligations included in Item 7, "Management's Discussion & Analysis of Results of Financial Condition and Results of Operations," of our Annual Report on Form 10-K for the year ended December 31, 2018.2019.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Foreign Exchange Risk
We operate on a global basis and are exposed to the risk that our earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange rates. We are primarily exposed to foreign exchange risk with respect to net assets denominated in the Euro, Swiss franc, British pound, Canadian dollar, Australian dollar and Brazilian real. As part of the TSA, Lilly maintained a foreign currency risk management program through a central shared entity, which entered into derivative contracts to hedge foreign currency risk associated with forecasted transactions for the entire company, including historically for our operations. Gains and losses on derivative contracts entered into by Lilly were previously allocated to our results to the extent they were to cover exposure related to our business and offset gains and losses on underlying foreign currency exposures. We implemented our own foreign currency risk management program and assumed all hedging activities in the second quarter of 2019.
We face foreign currency exchange exposures when we enter into transactions arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. We also face currency exposure that arises from translating the results of our global operations to the U.S. dollar at exchange rates that have fluctuated from the beginning of the period. We may enter into foreign currency forward or option derivative contracts to reduce the effect of fluctuating currency exchange rates in future periods, but our historical results do not reflect the impact of any such derivatives related to our exposure to foreign currency impacts on translation.periods.
We estimate that a hypothetical 10% adverse movement in all foreign currency exchange rates related to the translation of the results of our foreign operations would decrease our net income by approximately $4.6$1.5 million for the ninethree months ended September 30, 2019.March 31, 2020.
We also bear foreign exchange risk associated with the future cash settlement of an existing NIH.
In October 2018, we entered into a fixed interest rate, five-year, 750 million Swiss franc NIH against Swiss franc assets. The NIH is expected to generategenerated approximately $25 million in cash and contra interest expense per year; however, there is potentialin 2019 ($6.1 million for significant 2023 settlement exposure on the 750 million Swiss franc notional ifthree months ended March 31, 2019). In the first quarter of 2020, the U.S. dollar devalues versusstrength compared to the Swiss franc.franc allowed us to unwind and monetize approximately 75% of our Swiss franc NIH for a cash benefit of $26.7 million. We had an approximately 190 million CHF notional remaining on our NIH as of March 31, 2020. In April 2020, we liquidated our remaining position for a cash benefit of $8.3 million.
Interest Risk
We are exposed to interest rate risk on the long-term debt we incurred in connection with
Upon extinguishment of our IPO. Prior to our IPO, we did not have any interest rate exposure. We have cash flow risk associated with our $377.5 million of borrowings under the Term Credit Facility thatin the first quarter of 2020, our current outstanding debt balances are fixed-rate debt. While changes in interest rates currently have no impact on the interest we pay on fixed-rate debt, borrowings under our new term loan facility will be exposed to interest rate fluctuations based on variable rates. We actively monitor our exposure and may enter into financial instruments to fix theLIBOR. As of March 31, 2020, we held certain interest rate based on our assessmentswap agreements with a notional value of $4.05 billion that will have the economic effect of modifying the variable-interest obligations associated with the new Term Loan Facility, so that a portion of the risk.variable-rate interest payable becomes fixed. During the three months ended March 31, 2020, we recorded a loss of $39.2 million, net of taxes on these interest rate swaps in other comprehensive loss. The loss is primarily attributable to market conditions resulting from the COVID-19 pandemic and the resulting cut to interest rates by the U.S. Federal Reserve in the first quarter of 2020. See Note 11: Financial Instruments and Fair Value for further information.
Recently Issued Accounting Pronouncements
For discussion of our new accounting standards, see Note 4: Implementation of New Financial Accounting Pronouncements to our condensed consolidated and combined financial statements.
Item 4. Controls and Procedures
(a)Evaluation of Disclosure Controls and Procedures. Under applicable SEC regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company’s “disclosure controls and procedures,” which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.
Our management, with the participation of JeffJeffrey N. Simmons, president and chief executive officer, and Todd S. Young, executive vice president and chief financial officer, evaluated our disclosure controls and procedures as of September 30, 2019.March 31, 2020. Based on this evaluation, the chief executive officer and the chief financial officer concluded that the disclosure controls and procedures are effective.
(b)Changes in Internal Controls. During the thirdfirst quarter of 2019,2020, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. Other Information
Item 1. Legal Proceedings
(none)
Item 1A. Risk Factors
Other than the revisions set forth below, there have been no material changes from the risk factors disclosed in Part I of our Annual Report on Form 10-K for the year ended December 31, 2018 and Item 1A, "Risk Factors," of Part II of our Quarterly Reports on Form 10-Q for2019.
We have identified the quarterly periods ended June 30, 2019 and March 31, 2019.
Generic products may be viewed as more cost-effective than our products.following additional risk factor:
We face competition from products produced by other companies, including generic alternatives to our products. We depend on patents and regulatory data exclusivity periods to provide us with exclusive marketing rights for some of our products. Patents for individual products expire at different times based on the date of the patent filing (or sometimes the date of patent grant) and the legal term of patents in the jurisdictions where such patents are obtained.
The extent of protection afforded by our patents varies from jurisdiction to jurisdictionCOVID-19 pandemic has had, and is limited by the scope of the claimed subject matter of our patents, the term of the patent and the availability and enforcement of legal remedies in the applicable jurisdiction. In 2018, approximately 72% of our revenue was from products that did notexpected to continue to have, patent protection, including revenue from some of our top products such as Rumensin, Maxiban, Denagard and Tylan Premix®. Other products are protected by patents that expire over the next several years. For example, certain patents related to Trifexis expire as early as 2020 in the U.S., 2021 in Japan and 2025 in European territories. As the patents for a brand name product expire, competitors may begin to introduce generic or other alternatives, and as a result, we may face competition from lower-priced alternatives to many of our products. For example, we have experienced significant competitive headwinds from generic ractopamine in the U.S. In the third quarter of 2013, a large established animal health company received U.S. approval for generic ractopamine. U.S. revenue from Optaflexx, our ractopamine beef product, has declined at a compound annual growth rate of 24% from 2015 to 2018 as a result of generic competition and international regulatory restrictions. In the third quarter of 2019, an established animal health company received U.S. approval for generic monensin in cattle and goats for certain indications. U.S. revenue from Rumensin may decline as a result of the generic competition. We may face similar competition in the future for existing products that do not benefit from exclusivity or for existing products with material patents expiring in the future. See “Business of Elanco - Intellectual Property.”
Generic competitors are becoming more aggressive in terms of launching products before patent rights expire, and, because of attractive pricing, sales of generic products are an increasing percentage of overall animal health sales in certain regions. Although theadverse impact of generic competition in the animal health industry to date has not typically mirrored that seen in human health, product pricing and the impact of generic competition in the future may more closely mirror human health as a result of changes in industry dynamics, such as channel expansion, consolidation, an increase in the availability and use of pet insurance and the potential for generic competition by established animal health businesses. If animal health customers increase their use of new or existing generic products,on our business, financial condition andour future results of operations could be materially adversely affected.and our overall financial performance.
Significant portions
The recent outbreak of our operations are conductedCOVID-19 originating in EuropeWuhan, China, in December 2019, has since rapidly increased its exposure globally. On March 11, 2020, the World Health Organization declared the outbreak a pandemic. The pandemic has impacted and could be impacted by the withdrawal ofmay further impact the United Kingdom (UK) from the EU, commonly referred to as "Brexit."
In June 2016, voters in the UK approved an advisory referendum to withdraw from the EU, commonly referred to as Brexit. On March 29, 2017, the UK Prime Minister formally notified the European Council of the UK's intention to withdraw from the EU under Article 50 of the Treaty of Lisbon. The notice began a two-year negotiation period to establish the withdrawal terms. The EU has extended the end date of the negotiation period to January 31, 2020. The referendum and notice created political, regulatory and economic uncertainty, particularly in the UKStates and the EU,broader economies of affected countries, including negatively impacting economic growth, the proper functioning of financial and this uncertainty may persist for years if the withdrawal becomes effective without clarification as to whether the UK will continue to be partycapital markets, foreign currency exchange rates and interest rates. Due to the EU Free Trade Agreements (FTA) atspeed with which the end ofsituation is developing, the negotiation period.
Our business is subject to substantial regulation. If the UK withdraws from the EU without an agreement and mutual recognition of the EU FTAs, we may not be able to market certain products that entered the EU market following marketing authorization by UK authorities in all the nations that are parties to FTAs with the EU unless and until we have obtained all required regulatory approvals in each jurisdiction where we proposed to market those products.
global
breadth of its spread and the range of governmental and community reactions thereto, there is uncertainty around its duration, ultimate impact and the timing of recovery. Therefore, the pandemic could lead to an extended disruption of economic activity and the impact on our consolidated results of operations, financial position and cash flows could be material.
As a result of the adverse impact that the COVID-19 pandemic is having on our economy and the economies in the countries in which we operate, the pandemic is also affecting our operations, including our supply chain distribution systems, production levels and research and development activities. In addition, any preventive or protective actions that governments implement or that we adopt in response to the uncertainty relatedCOVID-19 pandemic, such as travel restrictions, quarantines, limited operations of governmental agencies or site closures, may interfere with the ability of our employees, vendors, and suppliers to Brexit has caused foreign exchange rate fluctuations in the past, including the strengthening of the U.S. dollarperform their respective responsibilities and obligations relative to the euroconduct of our business. In particular, as a result of the COVID-19 pandemic, due to the suspension of in-person interactions by our customer-facing professionals and British pound immediately following the announcementfact that certain vet clinics are limiting such interactions, our ability to market our products has been and may continue to be limited, which, in turn, could have an adverse effect on our ability to compete in the marketing and sales of Brexit. our products. Additionally, government regulations that have been imposed in response to the COVID-19 pandemic may cause delays in the receipt of products, causing delays in our global supply chain, delaying the transportation of finished goods, disrupting our freight processes, which would result in higher shipping costs, and causing resources to be diverted that are necessary to administer certain of our products. In addition, some research and development projects could be impacted based on need for the reagents from suppliers and clinical trial activity requiring veterinary clinic access and support. Furthermore, social distancing guidelines could have an adverse impact on our research and development activities as our laboratories are not operating at full capacity.
Our customers, and therefore our business and revenues, are sensitive to negative changes in economic conditions. As a result, we anticipate declines in revenue in 2020, including in our companion animal business as social distancing guidelines have decreased veterinary visits and have reduced veterinary practice spending. In addition, there have been a number of shutdowns of processing plants as a result of COVID-19 outbreaks within their operations, and there could be more of these shutdowns, which, in turn, may lead to decreased demand for our customers’ livestock. Such shutdowns could not only lead to a decrease in demand for our products, but could also significantly impact their ability to pay for our products. In addition, an effort by dairy farmers to decrease milk production could negatively impact demand for Rumensin. We expect the negative impacts of the COVID-19 pandemic on our revenue will continue until conditions relating to the overall impact of COVID-19 on all aspects of the economy and life in general improve.
The implementationimpact of the COVID-19 pandemic on the global financial markets may reduce our ability to access capital, which could negatively impact our short-term and long-term liquidity. Additionally, our third party distributors may face difficulties maintaining operations and normal liquidity in light of government-mandated restrictions. Further, the resulting global economic downturn has negatively impacted the ability of certain of our customers to make payments on a timely basis, adversely impacting our cash flows from operations. While our liquidity has not been significantly impacted by delayed collections thus far, we do not yet know the full extent of the impact of the COVID-19 pandemic and its resulting economic impact, which could have a material adverse effect on our liquidity, capital resources, operations and business.
We are also monitoring the impact of COVID-19 on our talent recruitment and retention efforts. If members of our management and other key personnel in critical functions across our organization are unable to perform their duties or further developmentshave limited availability due to COVID-19, we may not be able to execute on our business strategy and/or our operations may be negatively impacted. The loss or limited availability of the services of one or more of our executive officers or other key personnel, or our inability to recruit and retain qualified executive officers or other key personnel in the future, could, at least temporarily, have a material adverse effect on our business, financial condition and results of operations. Qualified individuals are in high demand, and we may incur significant costs to attract them, particularly at the executive level. We may face difficulty in attracting and retaining key talent for a number of reasons, including delays in the recruiting and hiring process as a result of the COVID-19 pandemic.
Our business, financial condition and results of operations could be materially adversely affected by unfavorable results in future employment litigation matters as result of COVID-19. Our employees may sue us due to possible exposure to COVID-19 while working at one of our facilities or sites. In addition, employees may challenge decisions to implement protective measures such as contact tracing on the basis of local privacy laws due to the increased collection of employee medical information. Litigation matters, regardless of their merits or their ultimate outcomes, are costly, divert management’s attention and may materially adversely affect our reputation and demand for our products. We cannot predict with respect to, Brexitcertainty the eventual outcome of pending or future litigation matters. An adverse outcome of litigation or legal matters could further impact foreign exchange rates, whichresult in us being responsible for paying significant damages.
Any of these negative effects resulting from litigation matters could materially adversely affect our business, financial condition andor results of operations. To the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in “Item 1A. Risk Factors” and elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2019.
A withdrawal with no deal in place
The following risk factors have changed from the risk factors that were previously disclosed:
An outbreak of infectious disease carried by food animals could significantly disruptnegatively affect the free movementdemand for, and sale and production of, goods, services, and people betweenour food animal products.
Sales of our food animal products could be materially adversely affected by the UK andoutbreak of disease or an outbreak carried by food animals, which could lead to the EU, and result in increased legal and regulatory complexities,widespread death or precautionary destruction of food animals as well as potential higher coststhe reduced consumption and demand for animal protein. In addition, outbreaks of conducting business in Europe and declining gross domestic product in many European markets. The UK's vote to exit the EU could alsodisease carried by food animals may reduce regional or global sales of particular animal-derived food products or result in similar referendumsreduced exports of such products, either due to heightened export restrictions or votes in other European countries inimport prohibitions, which we do business.may reduce demand for our food animal products due to reduced herd or flock sizes.
If no agreement is reached at the end
In recent years, outbreaks of the extended negotiation period on January 31, 2020various diseases, including African Swine Fever, avian influenza, foot-and-mouth disease, bovine spongiform encephalopathy (otherwise known as BSE or “mad cow” disease) and the UK's separation becomes effective, unless the remaining EU members unanimously agree to an additional extension, the uncertainty surrounding the terms of the UK's withdrawal and its consequences could adversely impact consumer and investor confidence, and could affectporcine epidemic diarrhea virus (otherwise known as PEDV) have negatively impacted sales or regulation of our animal health products. AnyThe discovery of additional cases of any of these, effects, among others, could materially adversely affector new, diseases may result in additional restrictions on animal protein, reduced herd or flock sizes, or reduced demand for animal protein, any of which may have a material adverse effect on our business, financial condition and results of operations. In addition, the outbreak of any highly contagious disease near our main production sites could require us to immediately halt production of our products at such sites or force us to incur substantial expenses in procuring raw materials or products elsewhere.
Risks Related to Pending Acquisition of Bayer Animal Health Business
The proposed acquisition of the Bayer animal health business of Bayer (Bayer Acquisition) may not be completed on the anticipated terms and there are uncertainties and risks related to consummating the Bayer Acquisition.
On
In August 19, 2019, we entered into a Purchase Agreementshare purchase agreement (Purchase Agreement) to purchase the animal health business of Bayer (Acquired Business) for approximately $5.3 billion in cash and approximately $2.3 billion of our common stock, subject to certain customary adjustments. Our obligation to consummate the Bayer Acquisition is subject to satisfaction or waiver, to the extent permitted under applicable law, of a number of conditions. Among other conditions, the Bayer Acquisition is subject to antitrust approvals in certain jurisdictions. The current COVID-19 global pandemic has resulted in the closure of certain U.S. and foreign governmental agencies for an extended period of time. These closures may extend antitrust filing timelines or impact our ability to form legal entities and obtain certain permits. We cannot provide any assurance that all required antitrust clearances will be obtained, and what conditions will be imposed. Even after the reopening of governmental agencies, limited staffing at those governmental agencies or other internal limitations, or limitations on Bayer's business, may negatively impact our ability to complete the Acquisition. There can be no assurance as to the cost, scope or impact of the actions that may be required, including divestiture actions,requirements, to obtain antitrust approval. If we are required to or otherwise decide to take such actions in order to close the Bayer Acquisition, it could be detrimental to the combined organization following the consummation of the acquisition.Acquisition, including with respect to the synergies which we expect from the Acquisition. For example, in January and February 2020, we signed agreements to divest Osurnia, a treatment for otitis externa in dogs, and the U.S. rights to Capstar, an oral tablet that kills fleas in dogs and cats, and Vecoxan, a treatment for coccidiosis in calves and lambs, for an aggregate of $285 million in all cash deals, with the intent to advance our efforts to secure the necessary regulatory clearances for the Acquisition. Furthermore, these actions, or the failure to effect any additional divestitures at an acceptable price or at all, could have the effect of delaying or preventing completion of the proposed Bayer Acquisition or imposing additional costs on or limiting the revenues or cash of the combined organization following the consummation of the acquisition.Acquisition.
Even if the parties receive antitrust approvals, the applicable domestic or international regulatory authorities could take action under the antitrust laws to prevent or rescind the Bayer Acquisition, require the additional divestiture of assets or seek other remedies. Additionally, state attorneys general could seek to block or challenge the Bayer Acquisition as they deem necessary or desirable in the public interest at any time, including after completion of the transaction.Acquisition. In addition, in some circumstances, a third party could initiate a private action under antitrust laws challenging or seeking to enjoin the merger,Acquisition, before or after it is completed. We may not prevail and may incur significant costs in defending or settling any action under the antitrust laws.
We may be unable to integrate the Acquired BusinessBayer animal health business successfully and realize the anticipated benefits of the Bayer Acquisition.Acquisition.
If the Bayer Acquisition is completed, the successful integration of the Acquired BusinessBayer animal health business and operations into those of our own and our ability to realize the expected synergies and benefits of the transactionTransactions are subject to a number of risks and uncertainties, many of which are outside of our control. We will also be required to devote significant management attention and resources to integrating business practices, cultures and operations of each business. The risks and uncertainties relating to integrating the two businesses and realizing the anticipated cost synergies include, among other things:
•the inability to achieve the anticipated revenue, earnings, accretion and other benefits due to the impact of the COVID-19 global health pandemic;
•the challenge of integrating complex organizations, systems, operating procedures, compliance programs, technology, networks and other assets of the Acquired Business;Bayer animal health business;
•the difficulties harmonizing differences in the business cultures of our company and the Acquired Business;Bayer animal health business;
•the inability to combine successfully combine our respective businesses in a manner that permits us to achieve the cost savings, synergies and other anticipated benefits from the Bayer Acquisition;
•the inability to minimize the diversion of management attention from ongoing business concerns during the process of integrating the Acquired BusinessBayer animal health business into our businesses;
•the inability to resolve potential conflicts that may arise relating to customer, supplier and other important relationships of our business and the Acquired Business;
•difficulties in retaining key management and other key employees; and
•the challenge of managing the expanded operations of a significantly larger and more complex company and coordinating geographically separate organizations.organizations; and
•difficulties in fully exploring intellectual property licensed from Bayer in connection with the acquisition, given Bayer's rights as licensor of such intellectual property.
We will incur substantial expenses to consummate the proposed Bayer Acquisition but may not realize the anticipated cost synergies and other benefits.benefits to the extent expected, on the timeline expected, or at all. In addition, even if we are able to integrate the Acquired BusinessBayer animal health business successfully, the anticipated benefits of the pending Bayer Acquisition may not be realized fully, or at all, or may take longer to realize than expected. Moreover, competition in the animal health industry, including competition that has negatively impacted results in the companion animal parasiticide market, may also cause us not to fully realize the anticipated benefits of the Acquisition. Given the size and significance of the Bayer Acquisition, we may encounter difficulties in the integration of the operations of the Acquired BusinessBayer animal health business and may fail to realize the full benefits and synergies of the Bayer Acquisition, which could adversely impact our business, results of operation and financial condition.
The Acquired Business may have liabilities that are not known
Breaches of our information technology systems or improper disclosure of confidential company or personal data, or a failure to us.
The Acquired Business may have liabilities that we failed,comply with privacy laws, regulations and our contractual obligations concerning data privacy or were unable, to discover in the coursesecurity of performing our due diligence investigations of the Acquired Business. We cannot assure you that the indemnification available to us under the Acquisition Agreement in respect of the Bayer Acquisition in connection with such agreement will be sufficient in amount, scope or duration to fully offset the possible liabilities associated with the business of the Acquired Business or property that we will assume upon consummation of the Bayer Acquisition. We may learn additionalcertain information about the Acquired Business that materially adversely affects us, such as unknown or contingent liabilities and liabilities related to compliance with applicable laws. Any such liabilities, individually or in the aggregate, could have a material adverse effect on our business, financial conditionreputation and results of operations.
Acquisition accounting adjustments could adversely affect our financial results.
We will account forrely on information technology systems to process, transmit and store electronic information in our day-to-day operations, including customer, employee and company data. The secure processing, maintenance and transmission of this information is critical to our operations. In addition, the completion of the Bayer Acquisition using the acquisition method of accounting. We will allocate the total estimated purchase price to net tangible assets, amortizable intangible assetslegal environment surrounding information security, storage, use, processing, transmission, maintenance, disclosure and indefinite-lived intangible assets, and based on their fair values as of the date of completion of the Bayer Acquisition record the excess, if any, of the purchase price over those fair values as goodwill. Differences between preliminary estimates and the final acquisition accounting may occur, and these differences could have a material impact on the consolidated financial statements and the combined company’s future results of operations and financial position.
Failure to complete the Bayer Acquisition could impact our stock price and our future business and financial results.
If the Bayer Acquisitionprivacy is not completed, our ongoing business and financial results may be adversely affected and we will be subject to a number of risks, including the following:
•depending on the reasons for the failure to complete the Bayer Acquisition, we could be liable to Bayer for monetary or other damages in connectiondemanding with the termination or breachfrequent imposition of the Purchase Agreement;new and changing regulatory requirements.
•
we have dedicated significant time and resources, financial and otherwise, in planning for the Bayer Acquisition and the associated integration, of which we would lose the benefit if the Bayer Acquisition is not completed;
•we are responsible for certain transaction costs relating to the Bayer Acquisition, whether or not the Bayer Acquisition is completed;
•while the Purchase Agreement is in force, we are subject to certain restrictions on the conduct of our business, including taking any action that is reasonably likely to prevent, materially delay or materially impair the consummation of the Bayer Acquisition, which restrictions may adversely affect our ability to execute certain of our business strategies; and
•matters relating to the Bayer Acquisition (including integration planning) may require substantial commitments of time and resources by our management, whether or not the Bayer Acquisition is completed, which could otherwise have been devoted to other opportunities that may have been beneficial to us.
In addition, if the Bayer Acquisition is not completed, we may experience negative reactions from the financial markets and from our customers and employees. We also may be subject to litigation related to any failure to complete the Bayer Acquisition or to enforcement proceedings commenced against us to perform our obligations under the acquisition agreement. If the Bayer Acquisition is not completed, these risks may materialize and may adversely affect our business, financial results and financial condition, as well as the price of our common stock.
WhileWe are generally dependent upon our technology systems to operate our business in normal periods, but in the Bayer Acquisition is pending,wake of the COVID-19 global pandemic, we are increasingly dependent on our information technology systems as our office workers, who are working remotely, rely on third-party applications to host a greater number of video conferences and Bayer willteleconferences, and are processing information through our network via their home networks, which may be subjectless secure.As such, our ability to effectively manage our business uncertainties that could adversely affectdepends on the security, reliability and adequacy of our respective businesses.
Our success following the Bayer Acquisition will depend in part upontechnology systems and data and the ability of usour employees to follow our cyber security policies and Bayerprotocols, including, but not limited to, maintain our respective business relationships. Uncertainty about the effectuse of VPN when remotely working on company matters, and other security protocols when using various video conferencing and teleconferencing applications, especially in light of the Bayer Acquisition on customers, suppliers,increased use of these tools due to the COVID-19 global pandemic.
We also store certain information with third parties, including the use of cloud technologies. Our information systems and those of our third-party vendors are subjected to computer viruses or other malicious codes, unauthorized access attempts, and cyber or phishing-attacks and also are vulnerable to an increasing threat of continually evolving cybersecurity risks and external hazards, as well as improper or inadvertent staff behavior, all of which could expose confidential company and personally identifiable information, as well as technology, networks, or infrastructure. Any such breach could compromise our networks, including a breach caused by a failure by our employees, working remotely or otherwise, to use such security policies and protocols, which could result in the loss of confidential company data, or an intrusion or business interruption by hackers that are able to access the company’s network or meetings taking place via video conferencing or teleconferencing, and the information stored or in the process of being transmitted or communicated could be accessed, publicly disclosed, lost or stolen. Any such loss or misappropriation of company data or other intrusion could cause a disruption of our operations and other constituencies may have a material adverse effect on usnegative consequences, such as increased costs for security measures or remediation costs, and diversion of management attention.
Any actual or perceived access, disclosure or other loss of information or any significant breakdown, intrusion, interruption, cyber-attack or corruption of customer, employee or company data or our failure to comply with federal, state, local and foreign privacy laws or contractual obligations with customers, vendors, payment processors and other third parties, could result in legal claims or proceedings, liability under laws or contracts that protect the Acquired Business. Customers, suppliers and others who deal with us or Bayer may delay or defer business decisions, decide to terminate, modify or renegotiate their relationships or take other actions as a resultprivacy of the Bayer Acquisition that could negatively affect the revenues, earnings and cash flowspersonal information, regulatory penalties, disruption of our company or the Acquired Business. If we are unableoperations, and damage to maintain these business and operational relationships, our financial position, resultsreputation, all of operations or cash flowswhich could be materially affected.
Our debt following the completion of the Bayer Acquisition will be significant and could adversely affect our business, revenue and our abilitycompetitive position. While we will continue to meet our obligations.
In connection with the Bayer Acquisition, we expectimplement additional protective measures to enter into new credit facilities, which would include $3.0 billion of term loans and a $750 million revolving credit facility. We have also obtained commitments for $2.75 billion of bridge loans which we may replace with proceeds from debt or equity financings.
This significant amount of debt and other cash needs could have important consequences to us, including:
•requiring a substantial portion of our cash flow from operations to make payments on this debt, thereby limiting the cash we have available to fund future growth opportunities, such as research and development, capital expenditures and acquisitions;
•restrictive covenants in our debt arrangements which could limit our operations and borrowing;
•reduce the risk of and detect cyber-incidents, cyber-attacks are becoming more sophisticated and frequent, and the techniques used in such attacks change rapidly. Our protective measures may not protect us against attacks and such attacks could have a future credit ratings downgrade of our debt increasing future debt costs and limiting the future availability of debt financing;
•increasing our vulnerability to general adverse economic and industry conditions and limiting our flexibility in planning for, or reacting to, changes insignificant impact on our business and industry,reputation. In addition, due to the need to use our cash to service our outstanding debt;
•placing us at a competitive disadvantage relative to our competitors that are not as highly leveragedTSA with debtLilly, we rely on Lilly for certain privacy, compliance, and thatsecurity functions, and personnel, and may therefore be more able to invest in their business or use their available cash to pursue other opportunities, including acquisitions;experience difficulties maintaining and
•limiting our ability to borrow additional funds as needed or take advantage of business opportunities as they arise.
In addition, our actual cash requirements in the future may be greater than expected. Our cash flow from operations may not be sufficient to repay implementing all of our outstanding debt as it becomes due,policies and we may not be able to borrow money, sell assets or otherwise raise funds on acceptable terms, or at all, to refinance our debt.
The issuance of our common stock to Bayer under the Purchase Agreement will be dilutive to our shareholders.
Following the closingpractices following completion of the Bayer Acquisition, Bayer will own our common stock valued at $2.3 billion based on trading prices before the closing, subject to a minimum and maximum number of shares as provided in the Purchase Agreement. The shares are subject to only limited lock-up obligations and following the expiration of such lock-up obligations (the latest of which expire 12 months after the closing of the Bayer Acquisition), Bayer is free to sell the shares received at closing. In addition, under the Purchase Agreement, we agreed to provide Bayer with customary shelf registration rights.
The market price of shares of our common stock may drop significantly as a result of the resale of shares issuable to Bayer at the closing, or when the lock-up restrictions on resale by Bayer lapse. In addition, this concentration of share ownership may adversely affect the trading price of our common stock because investors may perceive disadvantages in owning shares in a company with significant shareholders.
TSA for these services.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Upon closing the pending acquisition of Bayer's animal health business, we will issue shares of our common stock to Bayer with a value of approximately $2.3 billion in a private placement exempt from registration pursuant to Section 4(a)(2) of the Securities Act of 1933, as amended.
(none)
Item 3. Defaults Upon Senior Securities
(none)
Item 4. Mine Safety Disclosures
(none)
Item 5. Other Information
(none)
(none)
Item 6. Exhibits
The following exhibits are either filed or furnished herewith (as applicable) or, if so indicated, incorporated by reference to the documents indicated in parentheses, which have previously been filed or furnished with the Securities and Exchange Commission.
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| 101 | | | Interactive Data Files.Files |
| 104 | | | Cover Page Interactive Data File (formatted as Inline XBRL document and included in Exhibit 101) |
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | | | | | | |
| | ELANCO ANIMAL HEALTH INCORPORATED |
| | (Registrant) |
| | |
| Date: | November 8, 2019May 7, 2020 | /s/ Jeffrey N. Simmons |
| | Jeffrey N. Simmons |
| | President and Chief Executive Officer |
| Date: | November 8, 2019May 7, 2020 | /s/ Todd S. Young |
| | Todd S. Young |
| | Executive Vice President, Chief Financial Officer |