Elanco Animal Health Inc
NYSE:ELAN
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Elanco Animal Health Inc
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Ladies and gentlemen, thank you for standing-by. And welcome to the Elanco Animal Health Q3 Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will a question-and-answer session. [Operator Instructions]. Please be advised that today's conference is being recorded. [Operator Instructions].
I would now like to hand the conference over to your speaker, Jim Greffet, Head of Investor Relations. Thank you. Please go ahead, sir.
Good morning. Thank you for joining us for Elanco Animal Health's Q3 2019 earnings call. I'm Jim Greffet, Head of Investor Relations. Joining me on today's call are Jeff Simmons, our President and Chief Executive Officer; Todd Young, our Chief Financial Officer; and Katy Grissom from Investor Relations.
During this conference call, we anticipate making projections and forward-looking statements based on our current expectations. Our actual results could differ materially due to a number of factors including those listed on Slide 2 and those outlined in our latest forms 10-K and 10-Q filed with the Securities and Exchange Commission.
The information we provide about our products and pipeline is for the benefit of the investment community. It's not intended to be promotional and is not sufficient for prescribing decisions. You can find our press release, the slides referenced on this call and an investor workbook on elanco.com. The slides and the press release also contain further information about the non-GAAP financial measures that we discuss during today's call. After our prepared remarks, we'll be happy to take your questions.
I'll turn the call over to Jeff to provide the highlights. Jeff?
Thanks, Jim. Good morning, everyone. This quarter marks Elanco's fifth quarter as a public company. We are delivering to our expectations and we're pleased to show continued execution on all elements of our innovation portfolio and productivity strategy.
Let's begin with the highlights on Slide 3. We have outlined the importance of our three streamed governance structure in this pivotal time in Elanco's history. We have dedicated teams focused on; running Elanco, executing on our strategy and delivering results now and into the future, which is where the vast majority of Elanco employees are focused; secondly, standing up our independent operations; and lastly, closing and integrating the Bayer acquisition.
We are moving with purpose and urgency in each stream. First, our top-line results show the solid underlying demand for our products and the strength of our fundamentals, highlighted by the double-digit growth in our three targeted categories. Our portfolio approach enabled us to deliver 4% core revenue growth at constant currency. Our productivity efforts also continue to deliver, with a 210 basis point increase in our adjusted gross margin to 53.3%.
Second, we're building a fit-for-purpose company and establishing the standalone capabilities we need. In Q3, we took another action on this front announcing a restructuring and reduction in headcount. We also continue to exit Transition Service Agreements with Lilly including the go-live of our HR System workday this month.
Third, after announcing our planned acquisition of Bayer Animal Health, on August 20th, we have moved quickly to establish an experienced integration team to define monthly and quarterly integration activities with Bayer's senior management and launched the process with the regulatory bodies. We have had initial face-to-face meetings with the FTC and the European Commission. We’re engaged with regulators in all the jurisdictions where we're required to obtain competition clearance.
Our teams along with external advisors are working collaboratively and expeditiously with the regulators. Later in the call I'll reiterate a few key points on the Bayer acquisition.
Importantly, the vast majority of the Elanco employees are focused on running our business and delivering on our commitments. And you can see the results of this focus in our third quarter results. Meanwhile, we have the right teams established in executing on our standup and integration priorities. For our standup efforts, we've established a fit-for-purpose organization design and we're building an efficient infrastructure appropriate for our industry. For the Bayer integration, we have well developed capabilities having integrated 12 acquisitions over the past decade.
Let's move to Slide 4 and share some of the key events since our last earnings call across the three pillars of our strategy. First, our innovation strategy. It's built on launching with excellence, progressing our internal pipeline and complementing our internal pipeline with external opportunities. Our new products in launch mode continue to fuel our growth, increasing 75% year-over-year. The Group represented 15% of our total sales. This quarter we've added the sales of Entyce and Nocita from the Aratana acquisition and Tanovea from our commercial agreement with VetDC. You can see the growth trajectory of these products in constant currency on Slide 15.
Our internal pipeline is robust and projects are advancing, including a late-stage first-in-class innovation for poultry producers. In January 2018, we announced a development collaboration with Ab E Discovery to advance the development of a safe and novel approach for protecting chickens from coccidiosis and necrotic enteritis. Since this product is not an antibiotic, we expect there will be an attractive option for producers that have implemented a no antibiotics ever or NAE approach. Recall that 50% of the U.S. chicken production uses a NAE approach, where there is not a sustainable solution today for coccidiosis and necrotic enteritis. We're happy to share that we have received and achieved GRAS generally regarded as safe approval in all the key relevant states in the U.S. and are now piloting this solution as part of an NAE program with a U.S. major poultry producer.
We are working on a form for pelleted feed while the liquid formulation will be available to customers in early 2020. This program is an example of our focus on producers' most significant problems and our pursuit of alternatives to antibiotics. This will be a key, Elanco innovation launch in 2020.
Beyond this specific program, we recently completed our semi-annual portfolio review and I'm pleased with the state of our pipeline. We're excited about both the advancement and the flow of innovation with a goal of continue to deliver on average three innovative product launches per year over the next five years. We continue to invest in lifecycle opportunities to expand the global availability of recently launched products as well as focused on brand building and brand protection initiatives.
We've also fully integrated R&D programs from Aratana and Prevtec. And we're operating on our own platform with no dependencies on Lilly for R&D capabilities. In short, we've increased the speed and the value of the Elanco pipeline while maintaining R&D investment levels, and establishing standalone execution.
Now, on the portfolio, our targeted growth categories delivered double-digit growth and now represent about 63% of our total sales. Our portfolio approach is working and I'll provide more commentary about the performance momentarily.
Turning to our third pillar, productivity. The continued improvement in our gross margin is a reflection of the comprehensive productivity agenda throughout our company. And we made further progress in Q3. Our Board and management team are continually assessing our organization to identify and execute opportunities to advance our fit-for-purpose animal health structure across our value chain. As part of the restructuring we announced at the end of September, we expect to reduce approximately 250 positions to enhance productivity and drive efficiency.
Specifically, we're exiting and streamlining certain manufacturing and R&D sites. We’re consolidating and centralizing marketing and risk management functions. And we're adjusting the structure of regulatory functions to better align with the agencies they serve. This announcement is aligned with our previously communicated margin expansion goals. This action also enables us to increase investment in other areas of the business.
Through efforts like this, we increase our degrees of freedom on our growth and margin expansion agenda. Even while preparing for the Bayer integration, we will continue to drive our productivity agenda and optimize our operations. We have opened shared service centers in Warsaw, Poland and Kuala Lumpur, Malaysia, creating a back office structure that is fit for Elanco.
Additionally, we opened our Innovation and Alliance Center in Bangalore, India, providing key capabilities and capacity in support of a number of our business areas. The independent company stand-up and TSA exits remain on track. With the go-live of our HR System in November, representing a significant step in our journey, we've now migrated substantially all judgment based activities to Elanco staff. Lilly is now providing primarily data system related support and personnel-only.
Overall, our productivity agenda continues to progress and is delivering too, and in many cases above our expectations, all while increasing our speed and lowering our overall costs as we transition out of Lilly.
Now, let's take a look at our sales performance on Slide 5. I’ll start with Ruminants & Swine as that category has had a number of factors at play. Overall performance in Ruminants & Swine category reflects the continued impact of African Swine Fever, the supply disruption from our contract manufacturer for certain injectable products that we discussed in Q2, and some new external events. Let me note them.
As China swine prices have soared in awake of ASF, and trade negotiations have progressed, exports have become a more significant opportunity for U.S. producers. As a result, many farmers are moving away from ractopamine products to enable access to the China market. This impacts our swine product Paylean, which globally is less than 1% of our total sales.
Within our swine portfolio, we have another product called Skycis that is down in the market since 2012. Skycis has a different mode of action that we expect and see swine producers transitioning to this product as the lead alternative to Paylean. We believe that Skycis provides our customers with an attractive alternative to Paylean that does not have trade restrictions.
Second, a generic version of Rumensin was approved in Q3. Importantly, we see strong brand loyalty among our customers for Rumensin and we are very pleased with the durability and end user demand. As we expected, in the distribution channel, we’ve seen some changes in purchasing as they assess the environment. Important to know, we remain very confident in the value of Rumensin, the portfolio we offer our cattle customers and the value beyond product that differentiates Elanco from other players, particularly generics. In summary, things are tracking to our expectations with Rumensin.
And third, throughout 2019, the drought in Australia has been a headwind to the industry. With the other items impacting Ruminants & Swine category, this headwind has started to show-through in the results. All of these are known events that we've been planning for or are transient issues that will resolve. In the case of ASF over the long run this will likely improve animal husbandry practices in Asia and increase sophistication of farming practices, all of these positive for the industry and positive for Elanco. We are appropriately incorporating these environmental factors into our updated guidance for the year. Very importantly, the market shares of our key products match with our expectations. Furthermore, the fundamentals of our business, the underlying demand for our products and our execution are strong in the face of these uncontrollable market pressures.
Meanwhile, we're pleased in the results within our targeted growth categories which all show double-digit growth in the quarter. On a constant currency basis, Companion Animal Disease Prevention grew 11%, Companion Animal Therapeutics grew 10% and Future Protein & Health grew 20%. Our companion animal business was bolstered in Q3 by a purchase from a new customer that we had expected to close in Q4. Todd will provide additional commentary on our sales growth in a moment.
Let me pause and discuss our industry and our approach towards our outlook. This quarter is a perfect example of multiple variables in our industry and the importance of having a portfolio. Throughout this year we faced multiple headwinds to our business including the ones I just described as well as foreign exchange. Despite these challenges, we've been able to grow sales both organically and inorganically. This reinforces our approach to bring best-in-class solutions to our customers’ greatest needs to diversify across species, geographies, therapeutic classes and channels and to be flexible to bring innovation wherever it may be found.
I am pleased with our results, more importantly the resiliency and durability of our approach and the grade of our team across the world give me confidence for the future. Adding to my confidence is the temporary nature of these variables. We expect the impact of these items have on our growth to temper as we head into next year. The acute headwind of ASF in Asia will be less severe with reductions already seen in 2019. Over time, there will be benefits from the repopulation of swine, herd and advances in swine production. We're expecting China and Vietnam to return to growth next year. The supply secondly disruption that we have with our contract manufacturer is resolving. And the impact of Paylean is quantifiable, not material to our overall projections, and will be mitigated with other products such as Skycis.
This is the nature of our industry. We have the right strategy, products, people and focus to navigate such events while continuing to deliver for the long-term.
Now, I’ll turn the call over to Todd to provide more color on our Q3 results and financial guidance for 2019.
Thanks, Jeff. Slide 6 summarizes our presentation of GAAP results while Slide 7 describes the items considered in the adjusted financials. Slides 16 to 21 in the appendix provide a summary of adjustments made to the GAAP results to arrive at our adjusted presentation. I'll focus my comments on our adjusted measures to provide insights into the underlying trends in our business. So please refer to today's earnings press release for a detailed description of the year-on-year changes in our third quarter GAAP results.
Looking into adjusted measures on Slide 8, you'll see total Elanco revenue increased 1% in the quarter. On a constant currency basis, growth was 2%. Gross margin as a percent of revenue was 53.3% an improvement of 210 basis points over last year, driven by our manufacturing productivity initiatives, cost price, partially offset by product mix.
Our year-to-date gross margin is 53.6%. And we continue to expect the adjusted gross margin to be between 52% and 53% for the full year of 2019. As a reminder, Q4 is typically our lowest gross margin quarter as our product mix has a larger proportion of international poultry sales than in other quarters.
Operating expense increased 10% in the third quarter. Marketing, selling and administrative expense increased 7% to $192 million, reflecting additional costs from the acquired businesses in the current year, increased marketing efforts for our companion animal portfolio and incremental expense as a result of our operating as a public company, both new expenses and marginally higher expenses, specifically in the information technology.
R&D expense increased 19% to $70 million, or 9% of revenue before the additional costs from acquired businesses in the current year, primarily Aratana, timing of spend within the year, increased costs from R&D infrastructure investments, and increased project spend as a result of pipeline progression.
Operating income declined 2% reflecting increased operating expenses I just described, more than offsetting the improvement in gross margin. This decline was expected given the incremental expenses from acquisitions closed in the quarter. The operating margin in Q3 was 19%. As we had projected at the time we announced the Aratana acquisition, the increased operating expenses are personally offset by a benefit in other income and deductions. As the bottom-line, Q3 adjusted net income increased 4% to $111.7 million with an effective tax rate of 9.6%. The lower tax rate is due to a discrete tax benefit in the quarter from the resolution of a Brazil tax audit. Note that in the quarter net income was impacted by two one-time items. The discrete tax benefit I just mentioned was partially offset by an expense in other income and deductions related to the release of a tax indemnity associated with the resolution of the Brazil tax audit. Combined, the two items provide an incremental $7.2 million of net income or $0.02 of EPS.
Moving to Slide 9, let's take a look at the effective price, rate and volume on revenue growth. The effective foreign exchange rates on core revenue was a 1% headwind overall. Price grew 4% while volume was flat. On this slide, you can see the breakdown of revenue across our four categories. I will focus on constant currency growth.
Starting with Companion Animal Disease Prevention, which includes parasiticide and vaccines. Revenue grew 11% in the quarter, 4% from volume and 7% from price. Growth is driven by the continued uptake of Interceptor Plus and Credelio as well as vaccines. Price growth is driven mainly by vaccines which have a favorable comparison to the prior year.
Moving to Companion Animal Therapeutics, revenue increased 10% in the third quarter, 9% from volume and 1% from price. The growth is driven primarily by the continued uptake for
Galliprant as well as the inclusion of the Entyce and Nocita from Aratana which provided about 5 percentage points of growth in the quarter in this category. Both companion animal categories also benefitted from initial stocking for a new customer agreement that we'd expected in Q4 but that our team successfully delivered in Q3. Without this impact and addition of Aratana, total companion animal sales grew 3%.
Turning to our Food Animal portfolio of Future Protein & Health, revenue grew 20% in the quarter, 16% from volume and 4% from price. Growth in this category is driven primarily by the continued uptake of our Aqua portfolio as well as poultry products. The quarter also benefitted from discrete items including the sale of the remaining inventory of our product that will be phased out in China and a favorable comparison for the prior year for poultry products.
Ruminants & Swine revenue declined 11% in the quarter, driven by a 14% decline in volume, partially offset by a 3% increase in price. There are several environmental factors at play as Jeff described. These headwinds were partially offset by the inclusion of Posilac sales in the current quarter. As we discussed in the Q2 call, we have revised the commercial agreement with Lilly to sale the remaining inventory of Posilac.
Revenue from strategic exits decreased 33% for the quarter. Recall that the only two activities in this category are the contract vaccine manufacturing for BI and the production of human growth hormone for Lilly.
On Slide 10, we provide details on the overall performance in the U.S. and internationally. Both the U.S. and international businesses are contributing to overall growth.
Now turning to our financial guidance for the full year 2019 on Slide 11. We are updating our full year guidance for revenue and EPS. For total revenue, we now expect a range of $3.07 billion to $3.085 billion, a narrowing of the range and a $10 million reduction in the low end of the range. We continue to expect strategic exits to be approximately $80 million. We now project core revenue to grow 3% at constant currency and finish the year between $2.99 billion and $3.005 billion.
We are also updating the range for expected earnings per share. We now expect EPS on a GAAP basis to be between $0.10 and $0.18. On an adjusted basis, we are narrowing the range to be between a $1.04 and $1.08.
In summary, we are pleased with the progress of our margin expansion goals and confident in the underlying growth of our core business.
Before we take your questions, Jeff will provide an update on the Bayer acquisition.
Thanks, Todd. Bayer reported their third quarter results on October 30. And we are pleased to see the 10% constant currency growth in the animal health business, particularly the 22% growth in Seresto, 19% growth in the Advantage family and the calculated growth of the rest of the Bayer animal health business in the portfolio is more than 4%.
Beyond the favorable comparison quarter, the drivers of growth were aligned with our due diligence findings. The key growth drivers were the continued growth of alternative channels, the continued global brand expansion of Seresto, launches of both the Advantage family and Seresto in China, and the overall emerging market growth. These results reinforce the positive views developed during our thorough diligence. We're looking forward to completing the regulatory process and continue to target our close in mid 2020.
I think it’s key to remember that this transaction aligns with our IPP strategy and it positions Elanco to move from the position of strength to a position of leadership in a number of areas. First, we’d see it improved -- we will improve scale as the number two animal health company. We’ve balanced our sales nearly evenly across food and companion animals and nearly tripled our international companion animal business. We gained leading brands and capabilities in the increasingly important alternative companion animal channels. We expand our cattle portfolio and our emerging markets presence in both food and companion animal space. And we expect to achieve our current profitability targets more quickly and have greater headroom to expand profitability margins higher. And we believe we can garner these benefits without taking a step backwards on our current growth and margin expansion path.
We are even more excited for the opportunities before us as a combined company, and we're preparing to integrate Bayer quickly and efficiently. In the meantime, we are laser-focused on continuing to execute and deliver.
This concludes our prepared remarks. I'll now turn the call back over to Jim to moderate the Q&A.
Thanks, Jeff. We’d like to take questions from many callers as we can. So we ask you to limit your questions to two or a single question with two parts. Tina, if you could moderate, please, we're ready for the first question.
[Operator instructions]. And our first question comes from the line of Michael Ryskin with Bank of America.
Thanks for taking the question. First I want to start off on the moving pieces within the fiscal year revenue bridge. I appreciate the color you provided on ractopamine and the Rumensin. But could you give us a little more clarity on just how much of the impact you saw in third quarter and sort of what's built in your expectations for Ruminants & Swine for the year? Is that still $45 million headwind, is the injectable supply disruption still $15 million. And if you could provide a little color on the ractopamine international as well, that'd be helpful?
Mike, it’s Jim. I’ll give you some of the statistics and then maybe Jeff you can talk about there's lots of pushes and pulls as you appropriately noted, Mike. So on African Swine Fever, our expectations are the same as we delivered last quarter. So we're expecting a $40 million to $50 million headwind for the entire year. And we're at roughly $30 million year-to-date from what's happened. On the supply disruption, we think that is resolving. So we're cautiously optimistic for the fourth quarter. So we’re sticking with the $15 million to $25 million expectation for that headwind for the full year. And then Jeff maybe the -- all of the different pushes and pulls and where the growth is and then where it would be.
Yes, Michael, if you step back and just look at the pushes and pulls of the environmental factors that were noted specifically ASF, our third-party manufacturer, and it’s ractopamine and then you lay it against some of the inorganic plays such as Aratana and Posilac as well as our one-time customer purchase, they offset one another -- generally offset one another leading to the 4% growth.
Noting on Paylean, let me just mention as I've said, this is something that has been progressing over the years. It's not -- it maybe new in the news, but it hasn't been new in the industry and in the field. We have been building an alternative as I’ve mentioned with Skycis in our portfolio. And as we mentioned, Paylean is less than 1% globally. It's less than half of that here in the U.S. So again, non-material of any real significance and we're working with that transition to another program and an alternative product.
Tina, can we take the next question?
Yes. Our next question comes from Chris Schott with JPMorgan.
Great. Thanks very much for the questions. First one was just on Rumensin, can you just remind us or just walk through some of the assumptions that you have going forward as we think about the impact from generic competition in terms of both the magnitude of impact and how quickly you expect that erosion to occur just so that everyone is on the same page of how you're thinking about that?
My second question was just on the earnings progression this year. I think that the 4Q earnings imply a step down from what we've been seeing the last few quarters. I think it’s $0.23 at the midpoint versus $0.30 this quarter. Can you help me understand a little bit the dynamics there impacting that progression of earnings that we're seeing? Thanks very much.
Certainly, Chris. Jeff, you want to comment on that?
Yes, Chris. First of all, just again, strategy is working very well. I want to emphasize, it's tracking our expectations. And as we've said and we've modeled that there is an erosion in the first couple of years, the mix between price and volume. We've talked some about in the neighborhood of 30% over that first couple of years. What I really want to emphasize though is when we look at durability of the brand, durability of the total portfolio offered to cattle producers, the value beyond product as well as other means and measures competitively, what I would say is we're tracking at those expectations or even better and feeling very good about it.
The alteration that we've mentioned is really just a supply chain assessment that typically happens when you bring a generic to the market where people’s levels of inventories may change a little bit as they're assessing the marketplace. But again, I want to emphasize we are feeling very good relative to Rumensin and tracking our expectations.
Todd, you want to talk about Q4?
Sure, Chris, on the EPS change, obviously more important is the tax rate. We do expect the tax rate to be back in the low 20s in Q4, generally where we’re tracking in the year before getting this benefit from the Brazilian tax audit settlement. And then the other one would be on the gross margin side. As I mentioned in the prepared remarks, we do have a different mix in Q4. You would have seen that in last year's Q4 margin. We still expect the productivity initiatives to provide margin growth year-over-year, but just a lot of international poultry which is a lower margin product for us in Q4.
The other item is utilization of our plants. We have plant shutdowns within the year. And thus we don't have as much positive variations that we've had this year. So that's the main drivers of the progression, given we still expect a high revenue point for the full year here in Q4.
Thanks, Todd. Tina, do we have another question?
Our next question comes from Umer Raffat with Evercore.
Hi, guys. Thanks so much for taking my questions. Jeff, I wanted to focus on two main things in 2020. First, just the impact to Credelio, Interceptor as well as any flea, tick or worm portfolio out of Bayer. How does that get impacted from trio launch into 2020 and 2021? And secondly, you mentioned Rumensin is tracking in line with expectations. I know you said that several times today. Is it reasonable for us to assume a $50 million drop in Rumensin 2020? And is that consistent with the early feedback from distributors? Thank you very much.
Thanks, Umer for your questions. Look, I'll start by -- good question. We -- on the parasiticide market again continue to like the fundamentals. If you step back and look at the market, again, over a $5 billion market, compliance, channel, many other mechanisms, innovation, all driving really strong growth of the market. So let's start there, and we study that very closely. And I think we're working very closely also with the channel and with our customers and our sales team to continue to drive compliant ease-of-use for vets as well as pet owners.
I will also emphasize that we like our portfolio. Our portfolio offers competitive advantage. We're seeing that, you're seeing that in the results this quarter. We see that going into 2020. So what I will say is we're going to continue to see growth in this category for us, companion animal prevention. You're going to see continual leadership positions and share growth, we believe in our portfolio. Credelio Interceptor Plus noted, and so I'll emphasize that you'll hear and see the progress of that as we go into 2020.
I can't really note anything specifically on Bayer other than the fundamentals of the deal, and what we've said relative to what this does as it allows us to create leadership positions in the omni-channel to be able to access not only that vet clinic which is always the start, the priority, and I’d kind of say the start and the end of any pet relationship begins and ends in that vet clinic. But it also allows us to continue to really grow and meet the large segment that is not going into the clinic, or wanting a more convenient experience once they do have a product. So we see this increasing the strength of our total offer, both with Bayer’s portfolio, but also our own as well. So those are the comments.
On Rumensin, we're not going to give a specific guidance on a product. What we'll say is we give you some of the specifics and the modeling that we've had that comes from a lot of products seen over the years and a lot of markets very similar, feel very good about that. What I will say is as we look at our strategy, there’s ultimately -- and I think this is where our focus always has to be in these conversations is value proposition. It's not a pharmaceutical market, driven by government pay, this is a cash market, and cattle owners want value. They want total value. Rumensin is one element of that value proposition from Elanco and we’ll continue to expand that. But again, I'll stick with some of the modeling assumptions that I just shared with Chris. And we'll leave it at that.
Tina, next question?
Your next question comes from the line of David Risinger with Morgan Stanley.
Thanks very much. I have two questions. First, so could you quantify the three segment benefits to revenue in the third quarter? You mentioned two stocking benefits in the two companion animal segments. And then you mentioned a sale of remaining China product inventory as well. So just wanted to understand what those revenue items amounted to? And then second with respect to the Bayer acquisition timing, I believe that documents filed with the SEC state that the closing will be no earlier than July 1 of next year. Could you explain that and also discuss the two potential deal closing extensions that are mentioned as well? Thanks very much.
Todd, you want to address the..?
Sure. On the first, on the customer stocking, Dave, that was about $17 million in the quarter, something we planned on for the full year and the team did a great job of delivering that early. And that’s obviously part of the timing of the results and then the full year guidance. And then with respect to the China, that was single-digit millions, but due to protein health categories really led this quarter by our Aqua franchise, Clynav in Norway continues to really deliver as well as Invicta in Chile. And so we would’ve had double-digit revenue growth in Future Protein & Health even without this China item.
David, relative to the comments on closing the deal, I will start by saying great progress on the interactions with the anti-trust activities and the regulatory bodies. Good engagement. Our experts are working and our team is working very closely and things are tracking very nicely. So I'll say that.
And then I would say on the agreement that you mentioned about mid-2020, the assessment agreement, but there is an aspect of this that we have the liberty to close sooner if both parties agree. Of course we will pursue as soon as possible. There is many dimensions to lining that up from having our TSAs and our structure in place and financing. But what I'll say is we do have a stipulation to where both parties if they do agree we can close sooner.
Tina, next question?
Your next question comes from Kathleen Miner with Cowen & Company.
Thank you for taking the questions. Two questions. First on the Aqua and poultry market. Could you talk about your expectations for the market going forward? Will it be helped by the African Swine Fever and do you expect Elanco to beat those market growth expectations? And the second question just to go back to the fourth quarter EPS, and sort of the $0.02 that you took off the guidance for the full year, what were the specific things that really changed? Because my understanding is that Rumensin was on track, sterile injectables hasn't changed, swine fever hasn't changed. What were the particular items that caused you to lower the top-end of the range? Thank you.
A - Jim Greffet
Sure, Kathleen. Jeff, do you want to talk about that?
Yes, Kathy, as you can see the poultry market is doing very, very well for Elanco. We got our leadership position here with many portfolios against some of most significant problems that they have. And as I just mentioned we'll be introducing another technology in one of the larger markets with coccidiosis and necrotic enteritis with our new technology that's coming. So we feel very good about our position in this market and its position. And if you look at the U.S. poultry production it's expected this year to grow between 1% and 2%. What I would say is there is no one segment that's probably going to benefit more from African Swine Fever than poultry. As you've seen, the trade market has -- and trade has opened up for U.S. producers as well as other producers. And this will be the lead protein alternative to this. But I think also it can respond more quickly given breeding, supply chain too this as well.
So again we see a strong market for poultry going forward into 2020. We see a strong portfolio by us and our capabilities. We have made adjustments as an example inside of China to have a larger poultry field force to be able to respond to this and got a very strong portfolio. And this will be part of the return to growth in China by our poultry growth, and then of course, an introduction of innovation in 2020 as well, and one of the larger unmet need markets with the NAE market here in the U.S.
And then, Kathy, with respect to the EPS drop, a couple of things. We did mention our tracking, unfortunately -- the tracking close to the high end of our range versus the low end. We thought we'd get a little relief on the drought item and so the Paylean thing is new this quarter. And then there are some upsides we thought we had a chance of bringing in this year but we don't think that are materializing as we get closer to the full year and so we thought it made sense to reduce the guidance and give everyone a clear view where we expect to finish 2019.
And Kathy, I would just emphasize, I mean, we put our focus heavy on underlying demand for products, the value of our business and to our customers. And we feel very good about market shares, underlying fundamentals of the market and growth. These are environmental factors, and again, as we see them lessening or actually being out of the picture as we go into 2020.
Tina, next question.
Your next question comes from Kevin Ellich with Craig-Hallum.
Good morning. Thanks for taking the question. So, Jeff, just a couple things. First, cattle market in the U.S., clearly we know you're deemphasizing Food Animal Ruminants & Swine. But I just wanted to see what you guys are hearing about the varying market, is it stabilizing? And then what did you see with U.S. feed cattle this quarter as well? And then Todd with the Paylean and future ractopamine sales, we understand that you guys are going to switch people over to Skycis. But wondering if you could give us any sense of direction on the gross margin impact for the lost Paylean sales? Thanks.
Yes, thank you, Kevin. Let me start by saying, we actually see Ruminants & Swine as we go into 2020 as a important market for us. Yes, it wasn't part of the growth categories initially. But when you look at our portfolio, when you look at actually some of these environmental factors, becoming less as we go in, our contract manufacturing issue being resolved, a flattening out here in the China, Vietnam markets, still got to watch the other Asian markets.
We see Ruminants & Swine continuing to be a very important part of our business going forward. If I look at the cattle market overall, I think the U.S. beef market has stabilized as we talked about the fire and one of the major processing plants about 15% of the production, that has been picked up on Saturday and Sunday shifts that’s absorbed that. I think we're seeing overall slaughter capacity now is tracking nearly even with last year despite even this processing plant loss. I think in terms of placements, cattle placements, it appears the expansion period is kind of plateauing now, as we go forward into the rest of the year. I think another positive is the pasture, probably the best pasture conditions we've seen in many, many years. They're staying on grass longer, especially in North America, and that's coming into the feedlot later. That that bodes well with heavier weights coming in, resulting overall in good business but resulting in a few less days on feed in that feed yard.
So, as a whole I think it’s stabilizing market. They've weathered the processing plant change, and I think a pretty stable market going forward. There will be some advantage I think with this protein shortage, as more protein is going to be moving to Asia, but also just the underlying demand of protein growing and this shortage with African Swine Fever, beef will full benefit some, not as much as poultry and probably pigs, but it will benefit some.
Jeff any color on dairy, was the other....
Yes. Dairy is improving overall. It's come from a very tough three to four year period, but most is again regional milk prices but they’ve been breaking over breakeven. People are returning to profit. And again we feel very good about our current portfolio. And also the introduction of a broader portfolio on both beef and dairy with the Bayer acquisition.
And then Kevin on -- with respect to the Paylean, Skycis margin. They're pretty similar in their gross margin portfolio -- profile. So all, not a big difference there.
Tina, we can go to next question.
Your next question comes from Nathan Rich with Goldman Sachs.
Thanks for the questions, just two here. Jeff, firstly on the new customer agreement in the companion business, can you talk about the type of growth that you expect from this customer. And maybe kind of any unique aspects with respect to either volume commitments or pricing that you would call out? And any sense of profitability that you can give us for that contract? And then Todd, I also wanted to ask on operating expenses. It looks like they were up 10% year-over-year in the quarter. I think this was off a pretty good performance last year, so some of this just might be the comparison. But it's a little bit higher than what I think the run rate would be. So can you just give us any color there in terms of what drove the SG&A in the quarter?
Yes. Thank you Nathan for the question. We don't talk specifically about customers, but I will say, it brings a demographic of accretive growth and an attractive channel as we look at an omni-channel approach, this will be important. It will drive a broad base of a couple of our key brands in the companion animal space. And again, on profitability, we look at all of these deals from the standpoint of with the margin agenda that we have. We have to be extra scrutinizing on the total P&L on any customer contract. So we look at in a fully allocated P&L kind of a way. And what I would tell you is accretive to growth and not dilutive to margin. Those would be my high level comments.
Yes. Then Nathan with respect to OpEx you're right. Q3 of last year was sort of still on a carve out basis, full team wasn’t in place. And so it was a tough comp on an SG&A basis. We're actually down sequentially. From Q2 of 2019 a lot of focus on the other big item in this quarter was the Aratana and Prevtec acquisitions. Those came in the quarter with additional OpEx, those will be reduced going forward. So overall, we're very focused on our spend and staying in line with future expectations.
Tina, next question?
Our next question comes from the line of John Kreger with William Blair.
Hi good morning. This is Jon Kaufman on for Kreger. Thank you for the question. First, can you talk about the new product that you've added via acquisition recently? What's the initial response from your sales force and from veterinarians who weren’t previously aware of offerings like Entyce and Nocita. And then on African Swine Fever I think you said you expect China and Vietnam to grow next year. Are you seeing the producers in Asia successfully repopulate the swine herds that they lost? Thank you.
Yes Jon. So real quick, the first question was…?
Entyce and Nocita.
Yes, so we -- just on a full review on this And what I would say is, again, there's two dimensions to the demand creation. First is we've set up specialty sales force, primarily the Aratana sales force. We've ensured that they're in the right geographies. We put some of the Elanco brands into that portfolio as well. But what I would say is with some increase to support systems, technical people, resources as Todd mentioned, we're feeling very good but it's very early but we feel very good about that specialty sales force and what it’s going to do and it'll be a key part of our growth going forward.
As you go and look at our sales force that's much larger in the broader U.S. what we had with Entyce and Nocita was good placement in the clinics. We've now trained our sales force on these products, and now we're driving the demand in the clinics. That was what Aratana was unable to do. But I think the proof of the significance of these products is the actual number of clinics that we’re actually placed shows that there was interest, need, first-in-class product with Entyce a very unique product and Nocita on pain. Now we're in the mode now that our sales force is trained. And it is part of the call plan is to drive now the demand, but it isn't as much about getting placements, because they're there. It's about driving the demand through the clinic. So we feel very good about this. And, again, these will be key parts of our growth as we go into 2020.
Then swine repopulation?
Yes, so let me let me be clear on my comments. First of all, let me say that African Swine Fever, we've not turned the corner relative to we've seen cases during this quarter arise in the Philippines and in other markets. So across the Asian area, it continues to be a problem. I want to emphasize and we don't know and we got to keep our eyes out for other geographies, other continents that this could show up on. So there's no question that African Swine Fever is an endemic like we've not seen in decades. It's serious. There's not an easy solution. But I think the moves that are being taken in the first two markets that have hit the worst, China and Vietnam, the biosecurity, especially on those corporate operations are beginning a repopulation. What I want to emphasize is the Elanco business overall. So we've taken a hit as you see pretty materially to our overall affiliates in China and Vietnam.
What we see going forward with my comments is the mix of the total portfolio with poultry growth. And with a new base actually, that we're starting from in pigs, and moving again back into that B2B industrial relationship with those companies that are repopulating and of course biosecurity will be important but also multinational key brands will also be important.
Tina, next question.
Your next question is from Navin Jacob with UBS.
Hi, this is on Prakhar Agrawal on behalf of Navin. I just had a question on the Galliprant. Could you comment on the performance this quarter in U.S. and ex-U.S. and longer term how are you thinking about the competitive landscape for Galliprant brand, given potential launch have being products from your competitors, such as the NGF drugs? Thank you.
Yes, Galliprant continues to perform well, and we continue to as we've talked about, not only expand the number of clinics that are placing this compound, but also I think the biggest focus we've had is on actually awareness of osteoarthritis and we've launched a campaign to be able to create early understanding and diagnosis of arthritis. And I think this is important for the well being of pets. And so this will continue to drive and expand the market size. This is a no question a best-in-class product. We will continue to expand that. We're continuing to innovate behind it. We are continuing I think very important I mentioned Nocita, our pain portfolio continues to expand this quarter by bringing Nocita in. So I think that helps as we continue to be leaders in pain, bring key opinion leaders to the table for pain. But again Galliprant performed very well, met expectations, and we continue to see going forward. Competitive entries will continue to enter the marketplace that we're aware. We are going to continue to do what we do best which is, expand markets, deliver broad portfolios against big problems like pain and arthritis. And then of course innovate behind it ourselves.
Tina, do we have another question?
Yes. Our next question comes from Balaji Prasad with Barclays.
Hi, good morning thanks for taking my questions. So I have two questions. Firstly on -- I think we have discuss ASF broadly. I want to understand the base of replacement that poultry can provide with regard to the proteins lost globally. I mean, the latest USDA report shows around 30% shortage in global proteins. How much of this 30% can poultry replace under what timelines and how naturally think they can extrapolate this to your growth in poultry segment too?
Yes, it's a great question. I don't think there's an easy answer there by any means. I think that there's a few factors and we're involved in a lot of these is, first of all, the placements of birds is directly related to trade as well. So for anyone that's not in China in the poultry business, adding additional breeding stock and placement, that takes time. And that's also dependent on and it’s risk-based decisions by our poultry customers relative to trade. And you've seen some of that in some of the poultry reports and earning reports that have come out since the trade agreements.
It's good news, not just U.S. but I think globally, Brazil and others that will be able to take advantage of the shortage. So I think that's positive. I think, though it will be done in a staged way. And I don't think we're going to really be able to have an answer to your question to probably the second half of 2020 when we start to understand trade, restocking of pigs in China. And then, of course the economic state of the industries as well. So, I'll hold on that because I think the new projections on growth for the poultry industry has not come out and I would hold. But again, positive trends this quarter. Trade is more open than it was a quarter ago. And poultry placements and economics are strong. So I do see them being the lead protein to replace the missing pork.
Balaji, did you say you had a second question?
I don't know if your line still ...
Okay, Tina can we take the next question then?
Your next question is from Kevin Kedra with G. Research.
Thanks for taking the questions. First, on the price benefit in Companion Disease Prevention 7% pricing, you mentioned that's come from the vaccines portfolio. So if you might be able to give a little more detail on that? And then secondly, any change in the way that you're thinking about divestitures as you start working through the FTC process on Bayer?
Hey Kevin, it's Jim. So if you look back at Q3 of last year, we had actually talked about a benefit in disease prevention from some new customer agreements on our vaccine portfolio. And as all of these negotiations do, they involve an element of price as well. So that actually gave us a bit of a favorable comparison to the price from last year that amplifies the price benefit this year. So we wanted to call that out since 7% this quarter is higher than typical, and then I would emphasize look at the year-to-date where 2% both in disease prevention and 2% overall, which is the more steady state where we think the portfolio can track and where we'll be able to hopefully maintain that pricing over time.
Jeff, do you want to talk about?
Can’t note any specifics on the divestitures other than I would just make a comment that again, working very well with the jurisdictions; and two, we are preparing and will be prepared on any divestitures if needed, and will be done in a very timely way. And of course, in a very positive economical way as appropriate. But again, no comments on any specific products other than to say we are preparing and will be prepared.
Tina, do we have any more questions?
Yes. Our next question is from David Westenberg with Guggenheim Securities.
Hi, thanks for taking the question. So just on the Bayer acquisition, can you talk about maybe conversations you had with retailers that might have opened up because of the Bayer acquisition? And then with the focus on Europe where flea and tick meditations are largely OTC, what’s kind of the difference in terms of new market dynamics and in terms of getting into -- access to markets, and how does that differ from the U.S.?
And then for my second question, the step down in the Companion Animal Prevention category from Q2 to Q3 was kind of lower than I expected. And frankly, I think you called out a stocking order. Typically, with flea and tick season being kind of the back end in July, what does that large order or just Q3 revenue in general mean for maybe a year long compliance. Is that kind of picking up, is there an opportunity to grow Elanco? Thank you.
Any conversations with retailers or over-the-counter market specifically in Europe.
Yes, so just at a limited level we don't get into any specifics. Of course, we're competitors in the marketplace. And so we're careful but we do have the rationale for the deal. So we've been very, very clear with the customer base to understand it. I would even start with the veterinarians. We are very much -- and I think been accepted well by the veterinarians overall that we are a vet-driven and vet-centered company to start with, and we're going to utilize these additional channels as a way to support supplement, things like compliance and further adoption, but against starts and ends in the vet clinic.
And then I think on these alternative channels, retail channels, I think again, we are more than two years in with the retail business that we've been pretty open about. So those teams are of course, selling and representing our portfolio now and this does open the opportunity to just talk briefly about what can be relative to a broader portfolio that will come from Bayer. But -- and we're seeing seen nice growth in that alternative channel side and no real specific difference relative to Europe that we see. Again, a lot of the same dynamics that we see in the U.S.
On the sequential Todd I can offer some color too, what you’ve got?
Sure, we obviously we did have the stocking order that was both in parasiticide as well as in our Companion Animal Therapeutics category with Galliprant. Overall, Q2 typically the highest year for sales given the parasiticide season, no different for us this year with that category doing very well in Q2, continue on its trajectory in Q3, bolstered by us expanding the number of customers we're serving with our products.
With your question regarding are we expanding compliance in parasiticide, certainly an area we're focused on and working with customers, investors as clearly we think protection for animals all year around makes more sense than picking and choosing what months you want them protected from parasiticides. But we know that there's still an opportunity for greater growth across all the categories going forward.
If you look at the bar charts in the back of the slide deck as well you can see we have the breakdown of quarterly sales year-by-year for each category. So you can see this typical step down in Q3 and the disease prevention. We're almost at the hour. Maybe we have a couple more questions. Let's go quickly. If you ask your question quickly, we'll try to get through it.
Tina, if we can take another one?
Your next question is from Michael Ryskin with Bank of America.
Hi. Thanks for let me squeezing in a follow up. I got cut off there earlier. Really quick. If you exclude that stocking order that you called out for the companion animal business that was expected in 4Q and some of the M&A contribution of Aratana that you mentioned that companion animal businesses was only 3%, up 3% on a constant currency basis. And that's a little bit below our expectations. I mean, you highlighted the continued strength in Galliprant and Credelio and Interceptor. So is it true that if you look through the rest of the companion animal portfolio, some of the older products, are you seeing any incremental weakness there? Did something new happen where tied to timing or was there maybe just some distraction of sales force, given lot of the turnover. Could you just talked about sort of the rest of that business excluding the seasonality?
Hey Michael, there is there is some seasonality effects that Todd just mentioned. Q3 is a little bit of a different dynamic. That channel is a little dynamic. What I would say is, we feel very good about our year-to-date. We feel good about the quarter overall. Yes, there's some pushes and pulls in there, but is tracking very much to where we see the overall category so.
Mike it starts to get into a bit of watch building marginal things. Remember last year, there were some other issues with comparisons. We relaunched the high dose of Galliprant in Q3 of last year. So some of that is also influenced by just inflated comparison periods as well.
But again, I would say everything is in that category. And all three of our growth categories is tracking to our expectations. Underlying demand coming out of the clinics, and then the fundamentals in the market, it’s tracking to our expectations.
We’re a minute past the hour. Jeff if you want to do a quick close?
No. Thank you for the interest again five quarters as a independent company and delivering to our expectations through all five of those. I want to just emphasize our energy and focus is on execution, growth, innovation, nice progress with the innovation in the pipeline, and really good progress on margin expansion. Note that our focus is on that, as well as we're feeling very good to the progress in the tracking on standing up our company and the Bayer acquisition. So thank you for your interest and we look forward to continue dialogue going forward.
Tina, we can close.
Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.