ELANCO ANIMAL HEALTH INCORPORATED Management's discussion and analysis of financial condition and results of operations (MD&A), 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. For results of operations discussions related to years endingDecember 31, 2019 and 2018, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year endedDecember 31, 2019 filed with theSecurities and Exchange Commission onFebruary 28, 2020 . 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 pets and farm animals. Headquartered inGreenfield, Indiana , we are one of the largest animal health companies in the world, with pro forma combined revenue ofElanco and Bayer Animal Health of approximately$4.4 billion for the year endedDecember 31, 2020 . Excluding Bayer Animal Health, globally, we are #1 in medicinal feed additives, #2 in poultry, and #3 in other pharmaceuticals, which are mainly pet health therapeutics, measured by 2019 revenue, according to Vetnosis. We have one of the broadest portfolios of pet parasiticides in the pet health sector. We offer a diverse portfolio of approximately 190 brands that make us a trusted partner to veterinarians and farm animal producers in more than 90 countries. OnSeptember 24, 2018 , we completed our initial public offering (IPO), pursuant to which we issued and sold 19.8% of our total outstanding shares. OnSeptember 20, 2018 , our common stock began trading on theNew York Stock Exchange (NYSE) under the symbol "ELAN." OnSeptember 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. OnFebruary 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 theSEC in connection with that exchange offer. The disposition of Elanco shares was completed onMarch 11, 2019 , and resulted in the full separation of Elanco along with the disposal of Lilly's entire ownership and voting interest in Elanco. OnAugust 1, 2020 , we completed the acquisition ofBayer Animal Health . The acquisition expands our pet health product category, advancing our planned portfolio mix transformation and creating a better balance between our farm animal and pet health product categories. Our existing product portfolio and pipeline are enhanced by the addition ofBayer Animal Health , which complements our commercial operations and international infrastructure. See Note 6: Acquisitions and Divestitures to the consolidated and combined financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated and combined financial statements include the assets, liabilities, operating results and cash flows ofBayer Animal Health . 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. During the third quarter of 2020, we renamed our four primary product categories by replacing "food animal" and "companion animal" with "farm animal" and "pet health," respectively, to better reflect the terminology used by our customers. We advance our vision by offering products in these four primary 2020 Form 10-K | 46 [[Image Removed:
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categories:
Pet Health Disease Prevention (PH Disease Prevention): We have one of the broadest parasiticide portfolios in the pet health sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. Our Seresto and Advantage, Advantix, Advocate (collectively referred to as the Advantage Family) products represent treatments for the elimination and prevention, respectively, of fleas and ticks. Combining our parasiticide portfolio with our vaccines presence, we are a leader in theU.S. in the disease prevention category based on share of revenue. Pet Health Therapeutics (PH 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 theU.S. We also have treatments for otitis (ear infections) with Claro, as well as treatments for certain cardiovascular and dermatology indications. Farm 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 protein and includes innovative products in poultry and aquaculture production, where demand for animal health products is outpacing overall industry growth. With our Maxiban product, we are a leader in the control and prevention of intestinal disease in poultry. We are focused on developing functional nutritional health products that promote farm animal health, including enzymes, probiotics and prebiotics. We are also a global leader in providing vaccines as alternatives to antibiotics to promote animal health based on share of revenue. Farm Animal Ruminants & Swine (FA Ruminants & Swine): We have a range of farm animal products, including Rumensin and Baytril, used extensively in ruminant (e.g., cattle, sheep and goats) and swine production. A summary of our 2020, 2019, and 2018 revenue and net income is as follows: Year Ended December 31, 2020 2019 2018 Revenue$ 3,273.3 $ 3,071.0 $ 3,066.8 Net income (loss) (560.1) 67.9 86.5 Increases or decreases in inventory levels at our channel distributors can positively or negatively impact our quarterly and annual revenue results, leading to variations in quarterly revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, and procedures and environmental factors beyond our control, including weather conditions and the COVID-19 global pandemic. Key Trends and Conditions Affecting Our Results of Operations The animal health industry, which focuses on both farm animals and pets, is a growing industry that benefits billions of people worldwide. As demand for animal protein grows, farm animal health is becoming increasingly important. Factors influencing growth in demand for farm animal medicines and vaccines include: •one in three people needing 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 farm animal disease and death; 2020 Form 10-K | 47 [[Image Removed:
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•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 farm 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 pet medicines and vaccines include: •increased pet ownership globally; •pets living longer; and •increased pet spending as pets are viewed as members of the family by owners. Factors Affecting Our Results of Operations COVID-19 Pandemic Our business has been impacted by the COVID-19 pandemic that originated inDecember 2019 . We continue to monitor the global outbreak of COVID-19 and are working with our customers, employees, suppliers and other stakeholders to mitigate the risks posed by its spread. The COVID-19 pandemic continues to impact the economy inthe United States and globally, and has had an effect on the operations of our company, vendors and suppliers, and supply of and demand for our products as follows: Operations As a result of the COVID-19 pandemic, governmental authorities have implemented and are continuing to implement numerous and constantly evolving measures to try to contain the virus, such as travel bans and restrictions, limits on gatherings, quarantines, shelter-in-place orders, site closures and business shutdowns. These measures have affected the ability of our employees, vendors, and suppliers to perform their respective responsibilities and obligations relative to the conduct of our business. We have important manufacturing operations worldwide that have been impacted by the outbreak. Measures requiring business shutdowns generally exclude certain essential services, and those essential services commonly include critical infrastructure and the businesses that support that critical infrastructure. Because the animal health industry has been designated an essential business, our manufacturing and research facilities remain operational, while our employees in other company functions are primarily working remotely. These measures have impacted and may further impact our workforce and operations, as well as those of our customers, vendors and suppliers. Supply In 2020, we did not experience significant impacts or interruptions to our supply chain as a result of the COVID-19 pandemic. However, as the pandemic continues, we may face supply chain disruptions due to operational difficulties experienced by our suppliers in light of government-ordered restrictions and shelter-in-place mandates. Although we regularly monitor the financial health of companies in our supply chain, the financial hardship on our suppliers caused by the COVID-19 pandemic could cause a disruption in our ability to obtain raw materials or components required to manufacture our products, adversely affecting our operations. Freight processes have experienced, and could continue to experience, lead time disruptions and increases in shipping costs, negatively impacting our profitability. Demand The COVID-19 pandemic has adversely impacted global economic conditions. In particular, the COVID-19 pandemic has created near-term uncertainty for our channel distribution partners with respect to end customer demand and working capital. Based on these factors, in addition to a shift in tactics for demand generation with our distributors, in the first and second quarters of 2020, we reduced the amount of inventory held in the channel. We anticipate that decreases in end customer demand could impact our pet health business, primarily in clinically administered pharmaceutical products such as vaccines, and in international markets, as social distancing guidelines could decrease veterinary visits again in the future, reducing veterinary practice revenue and increasing working capital considerations for all parties in the value chain. If this occurs, even if we are able to increase sales 2020 Form 10-K | 48 [[Image Removed:
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in our direct to retailer and e-commerce channels, which have been important components of theBayer Animal Health distribution model, those increases may not compensate for reduced sales through veterinary practices. Further, demand in our direct to retailer and e-commerce channels could be negatively impacted if global economic conditions do not improve or if they deteriorate further. In our farm animal business, demand has been negatively impacted by processing plant closures, a backlog of animals ready for processing and pressured producer economics, which has and could continue to impact demand for a number of our farm animal products. While the impact has been most significant for theU.S. livestock industry, the pressure has occurred globally and across species. As the pandemic has continued through the beginning of 2021, our business has been affected by lower levels of demand in certain markets due to unfavorable macroeconomic conditions and reduced food service consumption trends. As a result, the industry has seen pressured prices and producer profitability across species, most notably in poultry and aqua. We anticipate that decreases in end consumer demand as compared to prior year will continue to occur, particularly in the farm animal business, into 2021. Our third party distributors may face difficulties maintaining operations and normal liquidity in light of government-mandated restrictions. Due to liquidity and working capital pressure caused by the COVID-19 pandemic, our distributors are managing inventory more tightly. In response to this along with a shift in tactics for demand generation with our distributors, we reduced channel inventory levels during the first half of 2020 as we tightened our approach across all facets of our distributor relationships. We estimate that this decreased our revenue by approximately$160 million . These actions have allowed us to improve working capital management, implement new compensation structures with our distributors and enable greater control of overall stock levels. We continue to monitor the impacts on our customers' liquidity and therefore our ability to collect on our accounts receivable. While our allowance on these receivables factors in expected credit losses, continued disruption and declines in the global economy could result in difficulties in our ability to collect, which we have not experienced on a material basis at this time. If significant issues with collections occur, material increases in our allowance for doubtful accounts may be required. Our Acquisition ofBayer Animal Health We have incurred and expect to continue to incur expenses in connection with our acquisition ofBayer Animal Health including fees for professional services such as legal, accounting, consulting, and other advisory fees and expenses. In addition, we have 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 and to expand administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by the former parent company ofBayer Animal Health . We anticipate that these additional costs will be partially offset by expected synergies. 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 PH Disease Prevention, PH 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$440.8 million to revenue for the year endedDecember 31, 2020 . This excludes our most recent acquisition ofBayer Animal Health , which added approximately 65 products to the Elanco portfolio that contributed post-acquisition revenues of$591.9 million in 2020. The Advantage Family and Seresto contributed approximately$151 million and$84 million , respectively, to our revenues in 2020. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depends on both our pipeline of new products, including new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization. Impact of Competition The animal health industry is competitive. Established animal health companies which consistently deliver high quality products enjoy brand loyalty from their customers, which often continues after the loss of patent-based or regulatory exclusivity. In animal health, while potentially significant, erosion from generic competition is often not as 2020 Form 10-K | 49 [[Image Removed:
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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 internationally for more than 10 years, our revenue from international Rumensin sales grew at a CAGR of 1% from 2015 to 2020. In the third quarter of 2019, an established animal health company receivedU.S. approval for generic monensin in cattle and goats for certain indications.U.S. revenue from Rumensin has declined as a result of the generic competition. Although we believe brand loyalty is an important contributor to a product's ongoing success, our pet health business can also be impacted by competition. For example, our Advantage Family products, acquired fromBayer Animal Health , are off-patent in most countries. If our customers increase their use of new or existing generic product alternatives, Advantage Family revenues could be adversely affected. 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. Prior to the acquisition ofBayer Animal Health , 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. The acquisition ofBayer Animal Health onAugust 1, 2020 added 3,900 full-time employees, eight manufacturing sites, and four R&D sites. In addition, from 2015 to 2020, 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 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 endedDecember 31, 2020 and 2019, approximately 49% and 44%, 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 theU.S. dollar impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements decreased revenue by 1% and 2% during the years endedDecember 31, 2020 and 2019, respectively. Currency movements had limited impact on revenue during the year endedDecember 31, 2018 . 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, veterinarians, and retailers. 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: •PH Disease Prevention includes parasiticides and vaccine products for dogs and cats; •PH Therapeutics includes products for the treatment of pain, osteoarthritis, otitis, cardiovascular and dermatology indications in dogs and cats; 2020 Form 10-K | 50 [[Image Removed:
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•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 farm animal products; and •Contract Manufacturing represents revenue from arrangements in which we act as a contract manufacturer, including supply agreements associated with divestitures of products related to the acquisition ofBayer Animal Health . This category was previously called Strategic Exits. 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 expense (income), net consists primarily of various items including net (gains)/losses on asset disposals, unrealized foreign exchange translation (gains)/losses, (gains)/losses on equity investments 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 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$280 million to$320 million , net of completed and potential real estate dispositions and employee benefit changes, of which a portion will be capitalized and the remainder will be expensed. As a result of the IPO, we became subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, and the Sarbanes-Oxley Act of 2002. We continue to establish and expand additional procedures and 2020 Form 10-K | 51 [[Image Removed:
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practices as a standalone public company. As a result, we continue to incur additional costs as a standalone public company compared to the prior period, including internal audit, external audit, investor relations, stock administration, stock exchange fees and regulatory compliance costs. Other Recent Acquisitions Our financial results have been impacted by other recent acquisitions and integrations. For the periods presented, these include primarily the acquisitions and integrations ofAratana Therapeutics, Inc. , which closed onJuly 18, 2019 , andPrevtec Microbia Inc. , which closed onJuly 31, 2019 . For more information, see Note 6: Acquisitions and Divestitures to our consolidated and combined financial statements. Asset Impairment, Restructuring and Other Special Charges During the years endedDecember 31, 2020 , 2019 and 2018 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 pet health products, product rationalizations, site closures and integration costs related to acquired businesses, primarilyBayer 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. 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. Year Ended December 31, % Change (Dollars in millions) 2020 2019 2018 20/19 19/18 Revenue $ 3,273.3$ 3,071.0 $ 3,066.8 7% -% Costs, expenses and other: Cost of sales 1,666.6 1,470.3 1,573.8 13% (7)% % of revenue 51% 48% 51% Research and development 327.0 270.1 246.6 21% 10% % of revenue 10% 9% 8% Marketing, selling and administrative 996.6 760.2 735.2 31% 3% % of revenue 30% 25% 24% Amortization of intangible assets 359.9 200.4 197.4 80% 2% % of revenue 11% 7% 6% Asset impairment, restructuring and other special charges 623.7 185.5 128.8 236% 44% Interest expense, net of capitalized interest 149.8 78.9 29.6 90% 167% Other expense (income), net (178.3) 27.4 41.3 NM NM Income (loss) before taxes (672.0) 78.2 114.1 NM NM % of revenue (21)% 3% 4% NM NM Income tax expense (benefit) (111.9) 10.3 27.6 NM (63)% Net income (loss) $ (560.1) $ 67.9 $ 86.5 NM NM Certain amounts and percentages may reflect rounding adjustments. NM - Not meaningful 2020 Form 10-K | 52 [[Image Removed: elan-20201231_g1.jpg]]
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Disaggregated Revenue
On a global basis, our revenue within our product categories was as follows:
Year Ended December 31, % Change
(Dollars in millions) 2020 2019 2018 20/19 19/18
PH Disease Prevention $ 992.7 $ 787.9 $ 804.6 26% (2)%
PH Therapeutics 365.8 348.0 283.1 5% 23%
FA Future Protein & Health 734.1 745.1 711.2 (1)% 5%
FA Ruminants & Swine 1,100.5 1,110.3 1,174.0 (1)% (5)%
Subtotal 3,193.1 2,991.3 2,972.9 7% 1%
Contract Manufacturing (1) 80.2 79.7 93.9 1% (15)%
Total $ 3,273.3 $ 3,071.0 $ 3,066.8 7% 0%
(1)Represents revenue from arrangements in which we act as a contract
manufacturer, including supply agreements associated with divestitures of
products related to the acquisition of Bayer Animal Health . This category was
previously called Strategic Exits.
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:
Bayer
Animal
Full year 2020 Health
(Dollars in millions) Revenue
Price FX Rate Legacy Elanco Volume Volume
Total CER*
PH Disease Prevention $ 992.7 6% -% (18)% 38% 26% 26%
PH Therapeutics 365.8 2% -% (8)% 11% 5% 5%
FA Future Protein & Health 734.1 3% (2)% (8)% 6% (1)% 1%
FA Ruminants & Swine 1,100.5 1% (1)% (17)% 16% (1)% -%
Core Revenue 3,193.1 3% (1)% (14)% 19% 7% 8%
Contract Manufacturing 80.2 1% (2)% (32)% 34% 1% 3%
Total $ 3,273.3 3% (1)% (15)% 20% 7% 8%
Full year 2019
(Dollars in millions) Revenue Price FX Rate Volume Total CER*
PH Disease Prevention $ 787.9 1% (1)% (2)% (2)% (1)%
PH 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%
Contract Manufacturing 79.7 -% -% (15)% (15)% (15)%
Total $ 3,071.0 2% (2)% -% -% 2%
Note: Numbers may not add due to rounding
*CER = Constant exchange rate
Revenue
PH Disease Prevention revenue increased by$204.8 million or 26%, primarily driven by the addition ofBayer Animal Health product revenue of$300.0 million , including Seresto and the Advantage Family, and price increases across the legacy Elanco portfolio. The volume decrease in the legacy Elanco business was the result of actions taken across brands to reduce channel inventory levels, a decrease in demand for older generation parasiticides as a result of competitor innovation, decreased demand in veterinary products as a result of the COVID-19 pandemic, an unfavorable comparison to the prior period which included an initial stocking for a new customer agreement in the third quarter of 2019 and the impact from products divested in the third quarter of 2020 as part of antitrust 2020 Form 10-K | 53 [[Image Removed: elan-20201231_g1.jpg]]
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considerations for theBayer Animal Health acquisition, partially offset by increases in sales through alternative channels outside vet clinics and increased demand for Credelio and vaccines. PH Therapeutics revenue increased by$17.8 million or 5%, driven by an increase in revenue fromBayer Animal Health products totaling$38.9 million as a result of the acquisition, price increases across the legacy Elanco portfolio and the inclusion of sales for Entyce and Nocita from the acquisition of Aratana beginning in the third quarter of 2019. The volume decrease in the legacy Elanco business was a result of actions taken across brands to reduce channel inventory levels, an unfavorable comparison to the prior period which included an initial stocking for a new customer agreement in the third quarter of 2019, and the impact from products divested in the third quarter of 2020 as part of antitrust considerations for theBayer Animal Health acquisition, partially offset by volume growth in the pain portfolio, including Galliprant. FA Future Protein & Health revenue decreased by$11.0 million or 1%, driven by decreased volume in the legacy Elanco portfolio and an unfavorable impact from foreign exchange rates, partially offset by the addition ofBayer Animal Health product revenue of$43.4 million and price increases across the legacy Elanco portfolio. The decrease in legacy Elanco volume was driven by lower levels of demand in certain markets due to the negative impact of the COVID-19 pandemic on poultry and aqua consumption, production, and profitability, as well as an unfavorable comparison to the prior period as a result of the sale of the remaining inventory of a product that was phased out inChina . FA Ruminants & Swine revenue decreased by$9.8 million or 1%, driven by decreased volume in the legacy Elanco portfolio and an unfavorable impact from foreign exchange rates, partially offset by the addition ofBayer Animal Health product revenue of$182.7 million and to a lesser extent an increase in price across the legacy Elanco portfolio. The legacy Elanco volume decrease was driven by reduced demand as a result of the impact of the COVID-19 pandemic on global protein markets, primarily Optaflexx, and actions taken across brands to reduce channel inventory levels, primarily Rumensin. Volume was impacted by generic competition for Rumensin, trade pressure affecting Paylean, and an unfavorable comparison to the prior period as a result of lower sales from the commercial agreement for Posilac. Additionally, higher demand inChina's swine market with favorable producer economics and positive efforts to repopulate herds impacted by African Swine Fever in 2019 was a partial offset to other revenue declines. Contract Manufacturing revenue increased by$0.5 million to$80.2 million and represented 2% of total revenue. Contract Manufacturing revenue for the period includes$26.9 million resulting from the acquisition ofBayer Animal Health . Cost of sales Cost of sales increased$196.3 million in 2020 as compared to 2019 due primarily to increased revenues and the amortization of the fair value adjustment to inventory of$90.1 million due to the acquisition ofBayer Animal Health , partially offset by manufacturing productivity improvements. Cost of sales as a percent of revenues increased to 50.9% from 47.9%, primarily due to the amortization of the fair value adjustment to inventory due to the acquisition ofBayer Animal Health , along with unfavorable product and geographic mix and unfavorable leverage of fixed manufacturing costs across a lower revenue base from the legacy Elanco portfolio, partially offset by continued improvements in manufacturing productivity and increases in price. Excluding the amortization of the inventory fair value adjustment, cost of sales would have been approximately 48.2% of revenue. Research and development R&D expenses increased$56.9 million to$327.0 million for 2020 as compared to 2019 primarily due to the acquisition ofBayer Animal Health and investments in our pipeline, partially offset by strong expense management and adjustments to variable pay. Marketing, selling and administrative Marketing, selling and administrative expenses were$996.6 million in 2020, an increase of$236.4 million compared to 2019, primarily due to the acquisition ofBayer Animal Health , re-investment in our Credelio and Galliprant commercialization efforts inChina and additional costs from acquired businesses in 2019, including Aratana and Prevtec, partially offset by disciplined cost management across the business as we have moved primarily to virtual operations due to the COVID-19 pandemic and adjustments to variable pay. 2020 Form 10-K | 54 [[Image Removed:
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Amortization of intangible assets Amortization of intangible assets increased$159.5 million to$359.9 million for 2020 as compared to 2019, primarily due to the addition of amortization of intangible assets recorded from the acquisition ofBayer Animal Health during 2020. 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. Asset impairment, restructuring and other special charges increased$438.2 million to$623.7 million in 2020 as compared to 2019, primarily due to severance associated with the restructuring program announced during the third quarter of 2020 as well as higher transaction costs directly related to business acquisitions, including the acquisition ofBayer Animal Health , higher integration costs of acquisitions, and costs associated with the implementation of new systems, programs, and processes due to the Separation from Lilly and in connection with the acquisition ofBayer Animal Health , as more fully described in Note 7. Interest expense, net of capitalized interest Interest expense increased$70.9 million to$149.8 million for the year endedDecember 31, 2020 , primarily due to incremental interest as well as debt issuance costs associated with the term loan B used to finance theBayer Animal Health acquisition, partially offset by a decrease related to the repayment of indebtedness outstanding under our existing term loan facility during the first quarter of 2020. Other expense (income), net Other expense (income), net was$178.3 million in income for 2020 compared to an expense of$27.4 million in 2019. Other income recorded in 2020 is composed of$156.7 million of gains recorded on the divestitures of certain products (see Note 6: Acquisitions and Divestitures for further discussion), the$45.6 million gain on the sale of land and buildings inNew South Wales, Australia (see Note 14: Leases for further discussion),$11.0 million of increases in the fair value of equity investments, and$3.9 million of decreases in the fair value of the Prevtec contingent consideration (see Note 11: Financial Instruments and Fair Value for further discussion). We also recorded$36.3 million of expense related to financing commitment and advisory fees associated with the execution of theBayer Animal Health acquisition. Income tax expense Our historical income tax expense may not be indicative of our future expected tax rate. See "Comparability of Historical Results" for further discussion. Income tax expense was a benefit of$111.9 million , which was a decrease of$122.2 million in 2020 as compared to 2019. This is primarily due to a pre-tax loss, partially offset by a non-cash charge of$74.9 million relating to the establishment of valuation allowances onU.S. deferred tax assets. See Note 16: Income Taxes to our consolidated and combined financial statements. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our Credit Facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside of theU.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 theU.S. may be impacted by local regulations and, to a lesser extent, followingU.S. tax reforms, the income taxes associated with transferring cash to theU.S. See Note 16: 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. 2020 Form 10-K | 55 [[Image Removed:
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We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations which include principal and interest payments as well as interest rate swaps, operating lease payments, purchase obligations, and costs associated with the integration of the animal health business of Bayer. In addition, we have the ability to access capital markets to obtain debt refinancing for longer-term funding, if required, to service our long-term debt obligations. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants. 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 ofDecember 31, 2020 , cash and cash equivalents was$494.7 million , an increase of$160.7 million compared to$334.0 million atDecember 31, 2019 . We also held$10.7 million of restricted cash atDecember 31, 2020 , which is available solely to pay the remainder of the purchase for our businesses to Lilly. We have a corresponding liability recorded on our consolidated balance sheet and included in Payable to Lilly. Refer to the Consolidated and Combined Statements of Cash Flows for additional details on the significant sources and uses of cash for the years endedDecember 31, 2020 , 2019 and 2018. 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): 2020 2019 2018 20/19 19/18 Operating activities$ (41.0) $ 224.1 $ 487.3 $ (265.1) $ (263.2) Investing activities (4,779.2) (234.8) (127.0) (4,544.4) (107.8) Financing activities 4,953.9 (304.8) (35.2) 5,258.7 (269.6) Effect of exchange-rate changes on cash and cash equivalents 26.6 (16.9) 29.0 43.5 (45.9) Net (decrease) increase in cash, cash equivalents and restricted cash$ 160.3 $ (332.4)
Operating activities Our cash flow from operating activities decreased by$265.1 million from cash provided by operating activities of$224.1 million for the year endedDecember 31, 2019 to cash used for operating activities of$41.0 million for the year endedDecember 31, 2020 . The decrease in operating cash flows was primarily attributable to a decrease in net income from year to year. Cash flows from operating activities during the year endedDecember 31, 2020 also decreased due to increases in accounts receivable, inventories and other assets, the impact of which was partially offset by increases in accounts payable and other current liabilities. The COVID-19 global health pandemic and related economic downturn led to an increase in customer accounts receivable that were past due at the end of the first quarter of 2020; however, customer collections improved throughout the remainder of the year and payment terms decreased. In the past, we have extended our payment terms for distributors on occasion. Although we presently have no plans to do so in the future, it is possible that we will need to extend payment terms in certain situations as a result of the COVID-19 global health pandemic, competitive pressures and the need for certain inventory levels at our channel distributors to avoid supply disruptions. If so, such extensions of customer payment terms could result in additional uses of our cash flow. Investing activities Our cash flow used for investing activities increased$4,544.4 million , to$4,779.2 million for the year endedDecember 31, 2020 compared to$234.8 million for the year endedDecember 31, 2019 . The change was primarily 2020 Form 10-K | 56 [[Image Removed:
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driven by acquisition payments resulting from$5,170.1 million of cash consideration paid to acquireBayer Animal Health , partially offset by cash acquired of$168.8 million , as well as a$119.3 million increase in purchases of software as compared to prior year. The impact of these items was partially offset by proceeds of$434.7 million and$32.7 million from product divestitures required to close the acquisition ofBayer Animal Health and the net investment hedge settlement, respectively. Financing activities Our cash provided by financing activities was$4,953.9 million in 2020 as compared to cash used for financing activities of$304.8 million in 2019. Cash provided by financing activities in 2020 consists of proceeds from our borrowings under the term loan B and issuances of common stock and tangible equity units to finance the acquisition ofBayer Animal Health , partially offset by the retirement of our term loan A credit facility and pre-payments on our new term loan B credit facility. Cash used for financing activities during 2019 reflected$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. Capital Expenditures and Software Purchases Capital expenditures were$134.6 million during 2020, a decrease of$5.8 million compared to 2019. Purchases of software were$176.3 million during 2020, an increase of$119.3 million compared to 2019. We expect 2021 capital expenditures and software purchases to be approximately$170 million to$200 million . Description of Indebtedness For a complete description of our debt and available credit facilities as ofDecember 31, 2020 , see Note 10: Debt to our consolidated and combined financial statements. Off Balance-Sheet Arrangements Other than the commitments and contingencies disclosed in Note 16: Commitments and Contingencies, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, results of operations, or liquidity.
Contractual Obligations
Our contractual obligations and commitments as of
Our long-term debt obligations are comprised of our expected principal and
interest obligations and our interest rate swaps. Payments due under our
long-term debt obligations based on scheduled maturity dates are as follows:
Years
Less than 1 More Than 5
(Dollars in millions) Total year 1 - 3 Years 4 - 5 Years Years
Long-term debt obligations, including
interest payments $ 7,413.6 $ 758.6 $ 1,211.5 $ 1,163.1 $ 4,280.4 We used current period assumptions for interest rates to compute expected interest payments on variable rate debt instruments and swaps.
Purchase obligations consist of open purchase orders as ofDecember 31, 2020 and contractual payment obligations with significant vendors which are noncancelable and are not contingent. These obligations are primarily short-term in nature. Critical Accounting Policies The preparation of financial statements in accordance withU.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Certain of our accounting 2020 Form 10-K | 57 [[Image Removed:
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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 and combined results of
operations. The fair values of intangible assets are 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 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
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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 endedDecember 31, 2020 , 2019 and 2018, we recorded asset impairments of$17.5 million ,$15.4 million and$81.9 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, amount and availability of taxable temporary differences, 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. Concluding that a valuation allowance is not required is difficult when there is significant negative evidence which is objective and verifiable, such as cumulative losses in recent years. We prepare a rolling three-year cumulative pre-tax book income or loss analysis adjusted for certain permanent book to tax differences as a measure of our cumulative results in recent years. In theU.S. and certain foreign jurisdictions, our analysis indicates that we have cumulative three-year historical losses on this basis. This is considered significant negative evidence which is objective and verifiable and therefore, difficult to overcome. However, the three-year cumulative loss position is not solely determinative and accordingly, we consider all other available positive and negative evidence in our analysis. In making such judgments, significant weight is given to evidence that can be objectively verified. As ofDecember 31, 2020 and 2019, we had valuation allowances of$94.4 million and$32.7 million , respectively. In recent years we have incurred pre-tax losses in theU.S. primarily as a result of transaction, restructuring, integration and other costs as well the negative impacts of the COVID-19 pandemic. As a result, we have concluded that it is "more likely than not" that we will not be able to utilize a portion of theU.S. deferred tax assets and have established a valuation allowance of$74.9 million against these deferred tax assets. Under current tax laws, the valuation allowance will not limit our ability to utilizeU.S. deferred tax assets provided we can generate sufficient future taxable income in theU.S. We anticipate that we will continue to record a valuation allowance against the losses until such time as we are able to determine it is "more-likely-than-not" the deferred tax asset will be realized. 2020 Form 10-K | 59 [[Image Removed:
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