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 consolidated and combined financial statements and accompanying
footnotes in Item 8 of Part II of this Annual Report on Form 10-K. Certain
statements in this Item 7 of Part II of this Annual Report on Form 10-K
constitute forward-looking statements. Various risks and uncertainties,
including those discussed in "Forward-Looking Statements" and Item 1A, "Risk
Factors," 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 & Co. (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 $3,071.0
million for the year ended December 31, 2019. Globally, we are #1 in medicinal
feed additives, #2 in poultry, and #3 in other pharmaceuticals, which are mainly
companion animal therapeutics, 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 along 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 Galliprant 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 only
antibiotics, serves the growing demand for

54

--------------------------------------------------------------------------------



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 years ended December 31, 2019, 2018 and 2017, our revenue was $3,071.0
million, $3,066.8 million and $2,889.0 million, respectively. For the years
ended December 31, 2019, 2018 and 2017, our net income (loss) was $67.9 million,
$86.5 million and $(310.7) 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, 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 on 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. 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.
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
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 have launched or acquired 14 new products,
including the additions of Entyce, Nocita and Tanovea in 2019. Revenue from
these products contributed $439.2 million to revenue for the

55

--------------------------------------------------------------------------------



year ended December 31, 2019. 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.
Impact of Changing Market Demand for Antibiotics
In recent years, our operational results have been, and will continue to be,
affected by regulations and changing market demand relating to the use of
antibiotics and other products intended to increase food animal production.
There are two classes of antibiotics used in animal health: (i) shared-class, or
medically important, antibiotics; and (ii) animal-only antibiotics. Shared-class
antibiotics are used to treat infectious disease caused by pathogens that occur
in both humans and animals. As part of our antibiotic stewardship plan and in
compliance with FDA guidance, shared-class antibiotics are labeled only for the
treatment of an established need in animals and only with veterinarian
oversight. However, not all pathogens that cause disease in animals are
infectious in humans, and accordingly animal-only antibiotics are not used in
human medicine (i.e., not medically important). From 2015 to 2019, our revenue
from shared-class antibiotics declined at a CAGR of 10%, excluding the impact of
foreign exchange. This was driven primarily by changing regulations in many
markets, including the Veterinary Feed Directive, as well as changing market
demand and Elanco's tiered-approach to antibiotic stewardship, which included
removing growth promotion from labels and requiring veterinary oversight in the
U.S. and other markets.
Globally, during 2019, our revenue from shared-class antibiotics declined 13%,
excluding the impact of foreign exchange, and represented 11% (4% from sales in
the U.S. and 7% from sales outside of the U.S.) of our total revenue, down from
16% in 2015. From 2015 to 2019, our revenue from animal-only antibiotics grew at
a CAGR of 4%, excluding the impact of foreign exchange, driven by sales outside
the U.S., which offset a slight decline in the U.S. Globally, during 2019, our
revenue from animal-only antibiotics declined 1%, excluding the impact of
foreign exchange, and represented 24% of our total revenue, up from 23% in 2015.
During 2019, 87% of our revenue from animal-only antibiotics resulted from the
sale of ionophores. Ionophores are a special class of animal-only
antimicrobials, and because of their animal-only designation, mode of action and
spectrum of activity, their use, to date have not been impacted by regulations
or changing market demand in many markets outside the U.S.
We have intentionally shifted away from shared-class antibiotics, and are
focusing on animal-only antibiotics, as well as antibiotic-free solutions. When
an animal-only antibiotic exists, we believe it should be the first, preferred
antibiotic treatment. Antibiotic resistance concerns, or other health concerns
regarding food animal products, may result in additional restrictions, expanded
regulations or changes in market demand to further reduce the use of antibiotics
in food animals. We believe it is important to protect the benefits of
antibiotics in human medicine, while responsibly protecting the health of food
animals and the safety of our food supply.
Impact of Competition
The animal health industry is competitive. Established animal health companies
who consistently deliver high quality products enjoy brand loyalty from their
customers, which often continues after the loss of patent-based or regulatory
exclusivity. In 2019, approximately 67% of our revenue was from products that
did not have patent protection. In animal health, while potentially significant,
erosion from generic competition is often not as steep as in human health, with
the originator often retaining a significant market share. However, generic
competition can nevertheless significantly affect our results. While our largest
product, Rumensin (monensin), has been subject to generic competition from
monensin outside the U.S. for more than 10 years, our revenue from Rumensin
sales outside the U.S. grew at a CAGR of 5% from 2015 to 2019. 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 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 ractopamine (the generic to our drugs Paylean and Optaflexx). U.S.
revenue for Paylean and Optaflexx, our ractopamine beef and swine products, has
declined at a CAGR of 44% and 21%, respectively, from 2015 to 2019 as a result
of generic competition and the impact of international regulatory restrictions.
In 2019, we had an estimated 70% market share of all U.S. ractopamine-treated
beef cattle based on management estimates.

56

--------------------------------------------------------------------------------



Although we believe brand loyalty is an important contributor to a product's
ongoing success, the animal health industry is also impacted by innovation. We
experienced an innovation lag in the companion animal parasiticide space from
2015 to 2017. In the absence of a competitive combined oral flea and tick
product, our U.S. companion animal parasiticide portfolio revenue declined 15%
in 2017, excluding the impact on revenue resulting from a reduction in inventory
levels within our distribution channel. In February 2018, we launched Credelio
in the U.S. for the treatment of fleas and ticks. Since the launch of Credelio,
our sales of parasiticides in the U.S. have begun to grow again.
Productivity
Our results during the periods presented have benefited from 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, 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 selling, general and
administrative (SG&A) functions. Our manufacturing cost savings strategies
included improving manufacturing processes and headcount through lean
manufacturing (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 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. For the
years ended December 31, 2019 and 2018, approximately 44% and 52%, 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 will 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% during the year ended December 31, 2019. Currency
movements had limited impact on revenue during the years ended December 31, 2018
and 2017.
General Economic Conditions
In addition to industry-specific factors, we, like other businesses, face
challenges related to global economic conditions. Growth in both the food animal
and companion animal sectors is driven in part by overall economic development
and related growth, particularly in many emerging markets. In recent years,
certain of our customers and suppliers have been affected directly by economic
downturns, which decreased the demand for our products.
The cost of our products to food animal producers is small relative to their
other production costs, including feed, and the use of our products is intended
to improve economic outcomes for food animal producers. Similarly, industry
sources have reported that pet owners indicated a preference for reducing
spending on other aspects of their lifestyle, including entertainment, clothing
and household goods, before reducing spending on pet care. While these factors
have mitigated the impact of recent downturns in the global economy, further
economic challenges could increase cost sensitivity among our customers, which
may result in reduced demand for our products and could have a material adverse
effect on our financial condition and results of operations.
Weather Conditions and the Availability of Natural Resources
The animal health industry and demand for many of our animal health products in
a particular region are affected by weather conditions, varying weather patterns
and weather-related pressures from pests, such as fleas and ticks. As a result,
we may experience regional and seasonal fluctuations in our results of
operations.

57

--------------------------------------------------------------------------------



Food animal producers depend on the availability of natural resources, including
large supplies of fresh water. Their animals' health and their ability to
operate could be adversely affected if they experience a shortage of fresh water
due to human population growth or floods, droughts or other weather conditions.
Drought conditions could negatively impact, among other things, the supply of
corn and the availability of grazing pastures. A decrease in harvested corn
results in higher corn prices, which could negatively impact the profitability
of food animal producers of ruminants, pork and poultry. Higher corn prices and
reduced availability of grazing pastures contribute to reductions in herd or
flock sizes that in turn result in less spending on animal health products. As
such, a prolonged drought could have a material adverse effect on our financial
condition and results of operations. Factors influencing the magnitude and
timing of effects of a drought on our performance include, but may not be
limited to, weather patterns and herd management decisions.
In addition, veterinary hospitals and practitioners depend on visits from and
access to the animals under their care. Veterinarians' patient volume and
ability to operate could be adversely affected if they experience prolonged
snow, ice or other severe weather conditions, particularly in regions not
accustomed to sustained inclement weather. Adverse weather conditions or a
shortage of fresh water may cause veterinarians and food animal producers to
purchase less of our products.
Disease Outbreaks
Sales of our food animal products could be adversely affected by the outbreak of
disease carried by animals, such as African Swine Fever. Outbreaks of disease
may reduce regional or global sales of particular animal-derived food products
or result in reduced exports of such products, either due to heightened export
restrictions or import prohibitions, which may reduce demand for our products.
Also, 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. Alternatively, sales of products that treat specific disease
outbreaks may increase.
Manufacturing and Supply
In order to sell our products, we must be able to reliably produce and ship our
products in sufficient quantities. Many of our products involve complex
manufacturing processes and are sole-sourced from certain manufacturing sites.
Minor deviations in our manufacturing or logistical processes, unpredictability
of a product's regulatory or commercial success or failure, the lead time
necessary to construct highly technical and complex manufacturing sites, and
shifting customer demand increase the potential for capacity imbalances.
Components of Revenue and Costs and Expenses
Revenue
Our revenue is primarily derived from sales of our products to third-party
distributors, and directly to food producers and veterinarians. For additional
information regarding our products, including descriptions of our products, see
"Item 1. Business - Products."
We aggregate our products into five categories to understand revenue growth:
•CA Disease Prevention includes parasiticides and vaccine products for dogs and
cats;
•CA Therapeutics includes products for the treatment of pain, osteoarthritis,
otitis, cardiovascular and dermatology indications in dogs and cats;
•FA Future Protein & Health includes vaccines, antibiotics, parasiticides and
other products used in poultry and aquaculture production, as well as functional
nutritional health products, including enzymes, probiotics and prebiotics;
•FA Ruminants & Swine includes vaccines, antibiotics, implants, parasiticides,
and other products used in ruminants and swine production, as well as certain
other food animal products; and

58

--------------------------------------------------------------------------------



•Strategic Exits includes business activities that we have either exited or made
the strategic decision to exit, including the transitional contract
manufacturing activity that we acquired in connection with our acquisition of
the BI Vetmedica U.S. vaccines portfolio, two terminated legacy U.S.
distribution agreements, a terminated distribution agreement outside the U.S.,
an equine product not core to our business and a transitional contract
manufacturing activity associated with the supply to Lilly of human growth
hormone.
Costs, Expenses and Other
Cost of sales consists primarily of cost of materials, facilities and other
infrastructure used to manufacture our products, shipping and handling,
inventory losses and expired products.
Marketing, selling and administrative expenses consist of, among other things,
the costs of marketing, promotion and advertising and the costs of
administration (business technology, facilities, legal, finance, human
resources, business development, external affairs and procurement).
Amortization of intangible assets consists of the amortization expense for
intangible assets that have been acquired through business combinations.
R&D expenses consist of project costs specific to new product R&D and product
lifecycle management, overhead costs associated with R&D operations, regulatory,
product registrations and investments that support local market clinical trials
for approved indications. We manage overall R&D based on our strategic
opportunities and do not disaggregate our R&D expenses incurred by nature or by
product as we do not use or maintain such information in managing our business.
Asset impairment, restructuring and other special charges consist primarily of
impairment of long-term assets, restructuring charges, costs associated with
acquiring and integrating businesses, and certain non-recurring expenses,
including costs related to the build out of processes and systems to support
finance and global supply and logistics, among others, to stand our organization
up as an independent company.
Interest expense, net of capitalized interest consists of interest incurred on
our long-term debt.
Other-net, expense (income) consists primarily of realized or unrealized foreign
exchange losses and loss or impairment on other investments.
Comparability of Historical Results
Our historical results of operations for the periods presented may not be
comparable with prior periods or with our results of operations in the future,
due to many factors, included but not limited to the factors identified in "Key
Trends and Conditions Affecting Our Results of Operations."
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
consolidated and combined financial statements reflect our 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 years ended December 31, 2019, 2018 and 2017 were $0.0 million, $105.2
million, and $151.7 million, respectively. See Note 20: Related Party Agreements
and Transactions to our consolidated and combined financial statements.

59

--------------------------------------------------------------------------------



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 consolidated and combined
financial statements reflect cash held only in bank accounts in our legal name
and no allocation of combined cash positions. Our 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 our interest expense of $78.9 million during
the year ended December 31, 2019.
For the periods prior to the IPO, our 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 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 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.
Subsequent to the IPO, we have implemented competitive compensation policies and
programs as a standalone public company. Our historical results prior to the IPO
reflect compensation costs that were allocated by Lilly.
As a result of the IPO, we became subject to the reporting requirements of the
Securities Exchange Act of 1934 and the Sarbanes-Oxley Act. We are continuing to
establish or 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, including internal audit, external audit, investor relations,
stock administration, stock exchange fees and regulatory compliance costs.
Recent Significant Acquisitions
Our financial results have been impacted by acquisitions and integrations. For
the periods presented, these include primarily the acquisitions and integrations
of Novartis Animal Health, which closed on January 1, 2015, Boehringer Ingelheim
Vetmedica, Inc.'s U.S. feline, canine and rabies vaccine portfolio and other
related assets (BIVIVP), which closed on January 3, 2017, Aratana Therapeutics,
Inc., which closed on July 18, 2019, and Prevtec Microbia Inc., which closed on
July 31, 2019. For more information, see Note 6: Acquisitions to our
consolidated and combined financial statements.
Asset Impairment, Restructuring and Other Special Charges
During the years ended December 31, 2019, 2018 and 2017 including in connection
with the productivity initiatives described above under "Key Trends and
Conditions Affecting Our Results of Operations - Productivity," we incurred
charges related to asset impairment, restructuring and other special charges,
including integration of acquired businesses. These charges include severance
costs resulting from actions taken to reduce our costs, asset impairment charges
primarily related to competitive pressures for certain companion animal
products, product rationalizations, site closures and integration costs related
to acquired businesses, primarily Novartis Animal Health, and costs related to
the build out of processes and systems to support finance and global supply and
logistics, among others, as we stand our organization up as an independent
company.

60

--------------------------------------------------------------------------------



For more information on these charges, see Note 7: Asset Impairment,
Restructuring and Other Special Charges to our consolidated and combined
financial statements.
Results of Operations
The following discussion and analysis of our consolidated and combined
statements of operations should be read along with our consolidated and combined
financial statements and the notes thereto included elsewhere in this report.
For more information, see Note 2: Basis of Presentation to our consolidated and
combined financial statements.

(Dollars in millions)                               Year Ended December 31,                                                               % Change
                                           2019               2018               2017               19/18                18/17
Revenue                                $ 3,071.0          $ 3,066.8          $ 2,889.0              -%                   6%
Costs, expenses and other:
Cost of sales                            1,470.3            1,573.8            1,493.9              (7)%                 5%
% of revenue                                  48  %              51  %              52  %
Research and development                   270.1              246.6              251.7              10%                 (2)%
% of revenue                                   9  %               8  %               9  %
Marketing, selling and administrative      760.2              735.2              779.8              3%                  (6)%
% of revenue                                  25  %              24  %              27  %
Amortization of intangible assets          200.4              197.4              221.2              2%                  (11)%
% of revenue                                   7  %               6  %               8  %
Asset impairment, restructuring and
other special charges                      185.5              128.8              375.1              44%                 (66)%
Interest expense, net of capitalized
interest                                    78.9               29.6                  -             167%                  NM
Other-net, expense (income)                 27.4               41.3               (0.1)             NM                   NM
Income (loss) before taxes                  78.2              114.1             (232.6)             NM                   NM
% of revenue                                   3  %               4  %              (8) %           NM                   NM
Income tax expense                          10.3               27.6               78.1             (63)%                (65)%
Net income (loss)                      $    67.9          $    86.5          $  (310.7)             NM                   NM


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:
(Dollars in millions)                   Year Ended December 31,                                           % Change
                                  2019            2018            2017         19/18       18/17
CA Disease Prevention         $   787.9       $   804.6       $   660.2        (2)%        22%
CA Therapeutics (1)               348.0           283.1           260.8        23%         9%
FA Future Protein & Health        745.1           711.2           649.2        5%          10%
FA Ruminants & Swine            1,110.3         1,174.0         1,175.0        (5)%        -%
Subtotal                        2,991.3         2,972.9         2,745.2        1%          8%
Strategic Exits (1)                79.7            93.9           143.8       (15)%       (35)%
Total                         $ 3,071.0       $ 3,066.8       $ 2,889.0        -%          6%


(1) Represents revenue from business activities we have either exited or made a
strategic decision to exit. On June 30, 2018, Elanco made the decision to exit
an equine product not core to its business. Revenue from this product is
reflected in Strategic Exits for the years ended December 31, 2019 and 2018 and
in CA Therapeutics for the year ended December 31, 2017. Revenue from this
product was $0.4 million, $1.6 million and $3.4 million for the years ended
December 31, 2019, 2018 and 2017, respectively.

61

--------------------------------------------------------------------------------



On a global basis, the effect of price, foreign exchange rates and volumes on
changes in revenue as compared to the prior year was as follows:
(Dollars in millions)
Full year 2019                    Revenue        Price        FX Rate         Volume        Total         CER*
CA Disease Prevention            $   787.9         1%           (1)%           (2)%          (2)%         (1)%
CA Therapeutics                      348.0         5%           (2)%           20%           23%          25%
FA Future Protein & Health           745.1         4%           (3)%            4%            5%           8%
FA Ruminants & Swine               1,110.3         1%           (2)%           (5)%          (5)%         (4)%
Core Revenue                     $ 2,991.3         2%           (2)%            1%            1%           3%
Strategic Exits                       79.7         -%            -%            (15)%         (15)%        (15)%
Total Elanco                     $ 3,071.0         2%           (2)%            -%            -%           2%



(Dollars in millions)
Full year 2018                    Revenue        Price        FX Rate         Volume        Total         CER*
CA Disease Prevention            $   804.6         8%            -%            14%           22%          22%
CA Therapeutics                      283.1         7%            1%             -%            9%           7%
FA Future Protein & Health           711.2         4%            -%             6%           10%          10%
FA Ruminants & Swine               1,174.0        (1)%           -%             1%            -%           -%
Core Revenue                     $ 2,972.9         3%            -%             5%            8%           8%
Strategic Exits                       93.9         -%            -%            (34)%         (35)%        (35)%
Total Elanco                     $ 3,066.8         3%            -%             3%            6%           6%


Note: Numbers may not add due to rounding
*CER = Constant exchange rate

Revenue


Total revenue
2019 vs. 2018
Total revenue increased $4.2 million or 0.1% in 2019 as compared to 2018,
reflecting a 2% increase in price, offset by a 2% unfavorable impact from
foreign exchange rates. Volume was flat as compared to prior year.
In summary, the total revenue increase was due primarily to:
•an increase in revenue of $72.0 million or 25% from CA Therapeutics products,
excluding the impact of foreign exchange rates; and
•an increase in revenue of $59.5 million or 8% from FA Future Protein & Health
products, excluding the impact of foreign exchange rates;
partially offset by:
•a decrease in revenue of $46.1 million or 4% from FA Ruminants & Swine
products, excluding the impact of foreign exchange rates;
•a decrease in revenue of $7.3 million or 1% from CA Disease Prevention
products, excluding the impact of foreign exchange rates;
•a decrease in revenue of $14.2 million or 15% from Strategic Exits, excluding
the impact of foreign exchange rates; and
•a decrease in revenue of $59.7 million due to the negative impact of foreign
exchange rates.

62

--------------------------------------------------------------------------------



The detailed change in revenue by product category was as follows:
•CA Disease Prevention revenue decreased by $16.7 million or 2%, driven by a
decline in volume and to a lesser extent the unfavorable impact of foreign
exchange rates, partially offset by an increase in price. The revenue decrease
was a result of several unfavorable comparisons to 2018. In 2018, vaccines
benefited from the initial stocking of a new customer agreement, customers
purchased higher than normal levels of parasiticides and vaccines to achieve
desired incentive levels across companion animal, and all remaining inventory
for Parastar was sold prior to rationalizing the product, all contributing to
the unfavorable comparison for the year. The decrease was also driven by
declines in sales of older generation parasiticides, partially offset by the
continued growth of Credelio and Interceptor Plus, including the initial
stocking of a new customer agreement in the third quarter of 2019.
•CA Therapeutics revenue increased by $64.9 million or 23%, driven by increased
volume and to a lesser extent price, partially offset by the 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 in the third quarter of 2019, and inclusion of sales of
Entyce and Nocita, as a result of the acquisition of Aratana.
•FA Future Protein & Health revenue increased by $33.9 million or 5%, driven by
both increased volume and price, partially offset by an unfavorable impact from
foreign exchange rates. Growth was driven by the aqua portfolio, poultry
vaccines and nutritional products, partially offset by the loss of sales for
certain products in China as a result of changing antibiotic policies.
•FA Ruminants & Swine revenue decreased by $63.7 million or 5%, driven by a
decline in volume and to a lesser extent the unfavorable impact of 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, decreased Rumensin sales as a
result of the generic entrant, and the impact from the Australian drought. These
decreases were 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 $14.2 million to $79.7 million and
represented 3% of total revenue.

2018 vs. 2017
Total revenue increased $177.8 million or 6% in 2018 as compared to 2017,
reflecting a 3% increase due to higher realized prices and a 3% increase due to
higher volumes.
In summary, the total revenue increase was due primarily to:
•an increase in revenue of $142.1 million or 22% from CA Disease Prevention
products, excluding the impact of foreign exchange rates;
•an increase in revenue of $18.4 million or 7% from CA Therapeutics products,
excluding the impact of foreign exchange rates;
•an increase in revenue of $63.8 million or 10% from FA Future Protein & Health
products, excluding the impact of foreign exchange rates and
partially offset by:
•a decrease in revenue of $0.8 million or 0% from FA Ruminants & Swine,
excluding the impact of foreign exchange rates and
•a decrease in revenue of $49.9 million or 35% from Strategic Exits, excluding
the impact of foreign exchange rates.
The detailed change in revenue by product category was as follows:
•CA Disease Prevention revenue increased by $144.4 million or 22% due primarily
to a reduction in channel inventory in 2017 providing a favorable year-on-year
comparison, continued uptake of Credelio and Interceptor Plus, as well as
realized price increases primarily impacting Trifexis, Capstar (a flea
treatment) and Comfortis, partially offset by volume declines in certain
parasiticides, primarily Trifexis and Comfortis volumes.

63

--------------------------------------------------------------------------------



•CA Therapeutics revenue increased by $22.3 million or 9% due primarily to the
continued uptake of Galliprant and Osurnia, as well as increased demand for
Onsior, partially offset by a temporary supply shortage of Percorten™ V used for
the treatment of canine Addison's Disease.
•FA Future Protein & Health revenue increased by $62.0 million or 10% due
primarily to the launch of Imvixa and the growth in poultry animal-only
antibiotics and poultry vaccines.
•FA Ruminants & Swine revenue decreased by $1.0 million due primarily to
competitive headwinds for ractopamine based products, offset by growth in
animal-only antibiotics, primarily in cattle.
•Strategic Exits revenue decreased by $49.9 million or 35% due primarily to the
termination of a legacy U.S. distribution agreement in the third quarter of
2017, partially offset by revenue from the contract manufacturing agreement to
supply human growth hormone to Lilly.
Costs, Expenses and Other
Cost of sales
2019 vs. 2018
Cost of sales decreased $103.5 million in 2019 as compared to 2018 due primarily
to manufacturing productivity improvements and charges recorded during the year
ended December 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.
2018 vs. 2017
Cost of sales increased $79.9 million in 2018 as compared to 2017 primarily due
to increased volume of products sold and the write-off of inventory related to
the suspension of activities for Imrestor in 2018, partially offset by
non-recurring costs incurred in 2017 associated with fair value adjustments to
inventory acquired in the BIVIVP acquisition and subsequently sold.
Research and development
2019 vs. 2018
R&D expenses increased $23.5 million for 2019 as compared to 2018 primarily due
to additional costs from acquired businesses during the year, including Aratana
and Prevtec, increased costs from R&D infrastructure investments, and project
spend as a result of pipeline progression.
2018 vs. 2017
R&D expenses decreased $5.1 million in 2018 as compared to 2017 due primarily to
cost control measures and timing of projects leading to lower spend in 2018.
Marketing, selling and administrative
2019 vs. 2018
Marketing, selling and administrative expenses increased $25.0 million for 2019
as compared to 2018 due primarily to additional costs from acquired businesses
during the year, primarily Aratana, and increased marketing efforts for our
companion animal portfolio, and increased expenses as a result of operating as a
standalone public company, partially offset by slightly lower selling costs and
lower costs due to continued productivity initiatives and cost control measures
across the business.
2018 vs. 2017
Marketing, selling and administrative expenses decreased $44.6 million in 2018
as compared to 2017 due primarily to productivity initiatives in sales and
administrative functions and reduced direct to consumer programs combined with
new product launches in 2017.

64

--------------------------------------------------------------------------------



Amortization of intangible assets
2019 vs. 2018
Amortization of intangible assets increased $3.0 million for 2019 as compared to
2018 primarily due to the addition of amortization of intangible assets recorded
from the acquisitions of Aratana and Prevtec in 2019 and the acceleration of the
amortization of certain software assets to be retired prior to the end of their
previously estimated respective useful lives due to our separation from Lilly.
2018 vs. 2017
Amortization of intangible assets decreased $23.8 million in 2018 as compared to
2017 due primarily to the acceleration of amortization related to certain
product exits in 2017.
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 consolidated and combined financial statements.
2019 vs. 2018
Asset impairment, restructuring and other special charges increased
$56.7 million in 2019 as compared to 2018 primarily due to higher transaction
costs directly related to business acquisitions, including 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 recorded in 2019,
as more fully described in Note 7.
2018 vs. 2017
Asset impairment, restructuring and other special charges decreased
$246.3 million in 2018 as compared to 2017 primarily due to a decrease in
severance related to the U.S. voluntary early retirement program offered in 2017
as well as a decrease in integration costs related to the BIVIVP acquisition in
2017, partially offset by a gain on disposal of a site that was previously
closed as part of the acquisition and integration of Novartis Animal Health in
2017.
Interest expense, net of capitalized interest
2019 vs. 2018
Interest expense increased $49.3 million for the year ended December 31, 2019
due to the timing of the issuance of debt in the third quarter of 2018.
2018 vs. 2017
Interest expense was $29.6 million for the year ended December 31, 2018 due to
our issuance of debt in the third quarter of 2018. There was no interest expense
in 2017 and prior years.
Other-net, expense (income)

2019 vs. 2018
Other-net, expense decreased $13.9 million from $41.3 million in 2018 to $27.4
million in 2019. The decrease in expense is primarily due to the increase in the
Aratana contingent consideration liability of $37.6 million associated with the
Galliprant acquisition recorded in 2018, partially offset by the impact of $8.3
million of expense recorded in 2019 due to the release of a tax indemnity asset
related to the 2015 acquisition of Novartis and $13.0 million of unfavorable
adjustments to the contingent consideration liabilities recorded for Galliprant
during 2019.

                                                                              65

--------------------------------------------------------------------------------



2018 vs. 2017
Other-net, expense (income) was expense of $41.3 million in 2018 compared to
income of $0.1 million in 2017. The increase in expense is primarily due to the
increase in the Aratana contingent consideration liability of $37.6 million
associated with the Galliprant acquisition.
Income tax expense
Elanco's historical income tax expense may not be indicative of its future
expected tax rate. See "Comparability of Historical Results, Our Relationship
with Lilly and Additional Standalone Costs."
2019 vs. 2018
Income tax expense decreased $17.3 million in 2019 as compared to 2018. The
decrease is primarily attributable to lower pre-tax earnings primarily due to
restructuring charges, in addition to the release of tax reserves related to
final resolution of the Brazilian tax matter. See Note 15: Income Taxes to our
consolidated and combined financial statements.
2018 vs. 2017
Income tax expense decreased $50.5 million in 2018 as compared to 2017. The
decrease is primarily due to a decrease in the U.S. valuation allowance, which
was recorded in 2017 based upon the pre-IPO separate return methodology. See
Note 2: Basis of Presentation and Note 15: Income Taxes to our consolidated and
combined financial statements.

Liquidity and Capital Resources
We historically participated in Lilly's centralized treasury management system,
including centralized cash pooling and overall financing arrangements. We have
generated and expect to continue to generate positive cash flows from
operations. In connection with the IPO, we entered into various long-term debt
agreements as described below.
Our primary sources of liquidity are cash on hand, cash flows from operations
and funds available under our 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. See Note 15: Income Taxes to our consolidated and
combined financial statements. We currently intend to indefinitely reinvest
foreign earnings for continued use in our foreign operations. 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 include funding existing marketed
and pipeline products, capital expenditures, business development in our
targeted areas, interest expense and funding the acquisition of the animal
health business of Bayer. We believe our cash and cash equivalents on hand, our
operating cash flows, our existing financing arrangements and financing
arrangements entered into in 2020 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 "Item 1A. Risk Factors - We may not be able to
generate sufficient cash to service all of our indebtedness and may be forced to
take other actions to satisfy our obligations under our indebtedness, which may
not be successful."
As of December 31, 2019, cash and cash equivalents was $334.0 million, a
decrease of $140.8 million compared to $474.8 million at December 31, 2018. We
also held $11.1 million of restricted cash at December 31, 2019, which is
available solely to pay the remainder of the purchase for our businesses to
Lilly. We have a corresponding liability recorded on our balance sheet and
included in Payable to Lilly. Refer to the Consolidated and Combined

66

--------------------------------------------------------------------------------



Statements of Cash Flows for additional details on the significant sources and
uses of cash for the years ended December 31, 2019, 2018 and 2017.
Cash Flows
The following table provides a summary of cash flows from operating, investing
and financing activities for the periods presented:
(Dollars in millions)                               Year Ended December 31,                                                           % Change
Net cash provided by (used for):            2019              2018             2017              19/18               18/17
Operating activities                     $  224.1          $ 487.3          $ 173.8                 (54) %              180  %
Investing activities                       (234.8)          (127.0)          (964.6)                 85  %              (87) %
Financing activities                       (304.8)           (35.2)           847.5                 766  %             (104) %
Effect of exchange-rate changes on cash
and cash equivalents                        (16.9)            29.0              7.9                (158) %              267  %

Net (decrease) increase in cash, cash equivalents and restricted cash $ (332.4) $ 354.1 $ 64.6

                (194) %              448  %


Operating activities
2019 vs. 2018
Our cash flow from operating activities decreased by $263.2 million from
$487.3 million for the year ended December 31, 2018 to $224.1 million for the
year ended December 31, 2019. The decrease in operating cash flows was primarily
attributable to a decrease in net income, increases in accounts receivable and
inventories, and changes in timing of payments in the ordinary course of
business.
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 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.
2018 vs. 2017
Our cash flow from operating activities increased by $313.5 million from $173.8
million for the year ended December 31, 2017 to $487.3 million for the year
ended December 31, 2018. The increase is a result of an increase in net income,
which was partially offset by cash used to finance working capital, primarily
focused on accounts receivable and inventory.
Investing activities
2019 vs. 2018
Our cash flow used for investing activities increased by $107.8 million, to
$234.8 million for the year ended December 31, 2019 compared to $127.0 million
for the year ended December 31, 2018. The change was primarily driven by cash
paid for the acquisition of Prevtec during 2019 and increases in purchases of
software from 2018 to 2019.
2018 vs. 2017
Our cash flow used for investing activities decreased from $964.6 million for
the year ended December 31, 2017 to $127.0 million for the year ended December
31, 2018. Our cash used in investing activities for the year ended December 31,
2017 included $882.1 million related to the acquisition of BIVIVP. This decrease
was offset by a net increase of $35.9 million in capital expenditures from 2017
to 2018.

67

--------------------------------------------------------------------------------



Financing activities
2019 vs. 2018
Our cash used for financing activities increased by $269.6 million to $304.8
million in 2019 compared to $35.2 million in 2018. Cash used in financing
activities during 2018 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 mostly
offset by $4.1 billion of payments to Lilly in connection with local country
asset purchases and other financing activities related to the Separation. During
2019, we made $121.1 million of payments on our term credit facility as well as
$191.6 million of payments to Lilly in connection with local country asset
purchases and other financing activities related to the Separation.
2018 vs. 2017
Our cash used for financing activities was a $35.2 million in 2018 compared to
cash provided by financing activities of $847.5 million in 2017, a change of
$882.7 million. The cash flows in 2017 relate to net cash provided by
transactions with Lilly of $848.3 million compared to cash used in transactions
with Lilly of $154.4 million in 2018, a reduction in financing of cash flows
between periods of $1.0 billion. This, in addition to the consideration paid to
Lilly in connection with the Separation, was partially offset by net cash
provided from financing transactions related to the Separation including the
proceeds from long-term debt and our IPO. The remainder of the proceeds from the
financing related to the Separation will be paid to Lilly in future periods and
is reflected as restricted cash in our consolidated balance sheet.
Capital Expenditures
Capital expenditures were $140.4 million during 2019, an increase of $5.9
million compared to 2018. We expect 2020 capital expenditures to be
approximately $150 million.
Description of Indebtedness
For a complete description of our debt and available credit facilities as of
December 31, 2019, see Note 9: Debt to our consolidated and combined financial
statements.
Contractual Obligations
Payments due under contractual obligations as of December 31, 2019, are set
forth below:
                                                                                                           Years
                                                                                                                                        More Than 5
(Dollars in millions)                                 Total(1)          Less Than 1 Year         1 - 3 Years         4 - 5 Years           Years
Long-term debt obligations, including
interest payments(2)                                $ 2,771.5          $          77.6          $    981.2          $  1,578.2          $   134.5
Operating leases                                         91.6                     26.0                32.2                16.9               16.5
Purchase obligations(3)                               1,127.4                  1,079.8                29.9                 7.7               10.0
Other long-term liabilities                              18.4                      5.7                 8.5                 0.8                3.4
Total                                               $ 4,008.9          $       1,189.1          $  1,051.8          $  1,603.6          $   164.4


(1) We excluded deferred taxes because we cannot reasonably estimate the timing
of future cash outflows associated with those liabilities.
(2) Our long-term debt obligations include both our expected principal and
interest obligations and our interest rate swaps. We used current period
assumptions for interest rates to compute expected interest payments on variable
rate debt instruments and swaps.
(3) Represents open purchase orders as of December 31, 2019 and contractual
payment obligations with each of our significant vendors which are noncancelable
and are not contingent.
In connection with our pending acquisition of the animal health business of
Bayer as discussed in Note 6: Acquisitions, 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. 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

68

--------------------------------------------------------------------------------



with Bayer. These fees have not been recorded on the consolidated balance sheet
as of December 31, 2019. See Note 22: Subsequent Events to our consolidated and
combined financial statements for updates regarding financing secured after the
balance sheet date.
Critical Accounting Policies
The preparation of financial statements in accordance with U.S. GAAP requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses. Certain of our accounting policies are
considered critical because these policies are the most important to the
depiction of our financial statements and require significant, difficult or
complex judgments by us, often requiring the use of estimates about the effects
of matters that are inherently uncertain. Actual results that differ from our
estimates could have an unfavorable effect on our financial position and results
of operations. We apply estimation methodologies consistently from year to year.
The following is a summary of accounting policies that we consider critical to
the consolidated and combined financial statements.
Revenue Recognition
Our gross product revenue is subject to deductions that are generally estimated
and recorded in the same period that the revenue is recognized and that
primarily represent revenue incentives (rebates and discounts) and sales
returns. For example:
•for revenue incentives, we use our historical experience with similar
incentives programs and current sales data and estimates of inventory levels at
our channel distributors to evaluate the impact of such programs on revenue and
continually monitor the impact of this experience and adjust as necessary; and
•for sales returns, we consider items such as: 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 to estimate the impact of sales returns.
If any of our ratios, factors, assessments, experiences or judgments are not
indicative or accurate predictors of our future experience, our results could be
materially affected.
Although the amounts recorded for these revenue deductions are dependent on
estimates and assumptions, historically our adjustments to actual results have
not been material. The sensitivity of our estimates can vary by program, type of
customer and geographic location. Amounts recorded for revenue deductions can
result from a complex series of judgments about future events and uncertainties
and can rely on estimates and assumptions.
See Note 4: Summary of Significant Accounting Policies to our consolidated and
combined financial statements for further discussion regarding our revenue
recognition policy.
Acquisitions and Fair Value
We account for the assets acquired and liabilities assumed in an acquisition
based on their respective fair values as of the acquisition date. The excess of
the purchase price over the fair value of the acquired net assets, where
applicable, is recorded as goodwill.
The judgments made in determining estimated fair values assigned to assets
acquired and liabilities assumed in a business combination, as well as estimated
asset lives, can materially affect our consolidated results of operations. The
fair values of intangible assets are re-determined using information available
at the acquisition date based on expectations and assumptions that are deemed
reasonable by management. These fair value estimates require significant
judgment with respect to future volume and prices, use of working capital, the
selection of appropriate discount rates, product mix, income tax rates and other
assumptions and estimates. Such estimates and assumptions are determined based
upon our business plans and when applicable, market participants' views of us
and other similar companies. Depending on the facts and circumstances, we may
deem it necessary to engage an independent valuation expert to assist in valuing
significant assets and liabilities.
We determine fair value of any contingent consideration liability that results
from a business combination by utilizing a market approach (i.e., based on
quoted market values, significant other observable inputs for identical or
comparable assets or liabilities) a discounted cash flow analysis, or a Monte
Carlo simulation (i.e., based on multiple potential financial outcomes using
estimated variables such as expected revenues, growth rates, and a

69

--------------------------------------------------------------------------------



discount rate). Estimating the fair value of contingent consideration requires
the use of significant estimates and judgments, including, but not limited to,
revenue and the discount rate and will be remeasured every reporting period.
Impairment of Indefinite-Lived and Long-Lived Assets
We review the carrying value of long-lived assets (both intangible and tangible)
for potential impairment on a periodic basis and whenever events or changes in
circumstances indicate the carrying value of an asset (or asset group) may not
be recoverable. We identify impairment by comparing the projected undiscounted
cash flows to be generated by the asset (or asset group) to its carrying value.
If an impairment is identified, a loss is recorded equal to the excess of the
asset's net book value over its fair value utilizing a discounted cash flow
analysis, and the cost basis is adjusted.
Goodwill and indefinite-lived intangible assets are reviewed for impairment at
least annually and when certain impairment indicators are present. When
required, a comparison of fair value to the carrying amount of assets is
performed to determine the amount of any impairment.
The estimated cash flows and fair values used in our impairment reviews require
significant judgment with respect to future volume; use of working capital;
foreign currency exchange rates; the selection of appropriate discount rates;
product mix; income tax rates and other assumptions and estimates. Such
estimates and assumptions are determined based upon our business plans and when
applicable, market participants' views of us and other similar companies. We
make these judgments based on our historical experience, relevant market size,
historical pricing of similar products and expected industry trends. These
assumptions are subject to change in future periods because of, among other
things, additional information, financial information based on further
historical experience, changes in competition, our investment decisions,
volatility in foreign currency exchange rates, and results of research and
development. A change in these assumptions or the use of alternative estimates
and assumptions could have a significant impact on the estimated fair values of
the assets, and may result in an impairment of the existing assets in a future
period.
During the years ended December 31, 2019, 2018 and 2017, we recorded asset
impairments of $15.4 million, $81.9 million and $110.6 million, respectively,
primarily due to product rationalization or changes in business strategy. For
more information related to our impairment charges, see Note 7: Asset
Impairment, Restructuring and Other Special Charges to our consolidated and
combined financial statements.
Deferred Tax Asset Valuation Allowances
We maintain valuation allowances unless it is more likely than not that all or a
portion of the deferred tax asset will be realized. Changes in valuation
allowances are included in our tax provision in the period of change. In
determining whether a valuation allowance is warranted, we evaluate factors such
as prior earnings history, expected future earnings, carryback and carryforward
periods, and tax strategies that could potentially enhance the likelihood of
realization of a deferred tax asset. The realizability assessments made at a
given balance sheet date are subject to change in the future, particularly if
earnings of a subsidiary are significantly higher or lower than expected, or if
we take operational or tax planning actions that could impact the future taxable
earnings of a subsidiary. A change in these assumptions may result in an
increase or decrease in the realizability of our existing deferred tax assets,
and therefore a change in the valuation allowance, in future periods. As of
December 31, 2019 and 2018, we had valuation allowances of $32.7 million and
$21.4 million, respectively.
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

70

--------------------------------------------------------------------------------



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 prior to 2018 do not reflect the impact of any such derivatives related
to our exposure to foreign currency impacts on translation.

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 $7.4 million for the
year ended December 31, 2019.
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, 5-year,
750 million Swiss franc NIH against Swiss franc assets. The NIH is expected to
generate approximately $25 million in cash and contra interest expense per year;
however, there is potential for significant 2023 settlement exposure on the 750
million Swiss franc notional if the U.S. dollar devalues versus the Swiss franc.
Interest Risk
We are exposed to interest rate risk on the long-term debt we incurred in
connection with our IPO. Prior to our IPO, we did not have any interest rate
exposure. We have cash flow risk associated with our $371.4 million of
borrowings under the Term Credit Facility that pay interest based on variable
rates. We actively monitor our exposure and may enter into financial instruments
to fix the interest rate based on our assessment of the risk.
Recently Issued Accounting Pronouncements
For discussion of our new accounting standards, see Note 4: Summary of
Significant Accounting Policies - Implementation of New Financial Accounting
Pronouncements to our consolidated and combined financial statements.

© Edgar Online, source Glimpses