Fitch Ratings has affirmed Elanco Animal Health Incorporated's (ELAN) and Elanco US Inc.'s Issuer Default Ratings (IDRs) at 'BB' and senior secured debt ratings at 'BBB-'/'RR1'.

Fitch has also affirmed ELAN's senior unsecured notes at 'BB'/'RR4'. Additionally, Fitch has assigned a 'BBB-'/'RR1' rating to the 2029 incremental term loans co-issued by Elanco Animal Health Incorporated and Elanco US Inc. and a 'BBB-'/'RR1' rating to the 2025 and 2028 incremental term loans at Elanco US Inc., a coborrower of the debt. The Rating Outlooks remains Negative.

The rating actions reflect the operating headwinds facing the company, though Fitch expects the company to still generate positive FCF and deleverage through a combination EBITDA growth and debt reduction.

Key Rating Drivers

Operating Environment Headwinds: Supply chain disruptions, coronavirus-related shutdowns in China, competitive pressure on Elanco's veterinarian-prescribed parasiticides and pressure in its retail market present operating challenges for Elanco. As a result, the company has extended its margin expansion timeline. In addition, one-time costs are now expected to be $550 million - $575 million in order to realize the roughly $400 million of synergies from Bayer transaction. These costs exceed what was originally expected owing to more headcount reduction and higher costs required for the integration of Bayer. The company has publicly restated its commitment to achieving 60% gross margin and 31% adjusted EBITDA margin.

Margin Improvement/Debt Reduction Required: Fitch expects both EBITDA growth and debt reduction to reduce leverage after the Bayer AG's animal health business acquisition in 2020. Advancing sales and margin expansion from the Bayer acquisition cost-related synergies and other efficiency gains should drive EBITDA growth. A forecasted return to growth in 2023, improving margins, manageable capex requirements and no cash dividend should support positive annual FCF during the forecast period. Fitch looks for ELAN to prioritize cash generation for debt reduction. Current operating headwinds and the Kindred Biosciences acquisition in 2021 highlights the need for solid execution in order for timely deleveraging to be achieved.

Advancing Pipeline: Elanco's legacy research and development efforts, the Bayer and the Kindred acquisitions have helped to strengthen the company's pipeline. The company recently launched Zorbium, a long-acting transdermal pain product for cats. It has garnered six regulatory approvals so far this year, including Credelio (China), Credelio Plus (Canada), and Advantage X (felines/U.S.). Elanco also looks to submit a broad-spectrum parasiticide and at least one dermatological treatment in the near term, and it entered into agreement for a diabetes therapy (felines) that has been submitted to the FDA.

Competitive Position in Animal Health: ELAN is the fourth largest company in the animal health industry with a global footprint and portfolio that spans the feed animal and pet health segments. Fitch expects the animal health category will benefit from long-term demand growth and the feed animal segment will be supported by population growth and increasing global protein consumption. Also, the pet health segment is expected to benefit from growing consumer expenditures. Further, Fitch expects revenues to be fairly durable relative to broader corporate industrial companies given that ELAN's products benefit from some level of differentiation and patent exclusivity.

ELAN is also expected to benefit from durable revenues relative to pharmaceutical companies given its more fragmented and notably private-pay customer base as opposed to public and commercial third-party payers. Fitch views ELAN's scale and portfolio reach as a competitive advantage allowing it to serve a global customer base with its intellectual property and to buffer against the consolidation of its end customers.

Acquisitions Improved Business Profile: The acquisitions of Bayer AG animal health business and Kindred Biosciences have strengthened the company's competitive profile with greater product diversification, reduced reliance on antibiotics and scale benefits such as an improved competitive position relative to Zoetis Inc., stronger relative bargaining power with suppliers and customers (e.g. group purchasing organizations) and more products to sell through its sales and marketing infrastructure. Also, the transactions reduce ELAN's reliance on the farm animal segment, which has been pressured by a variety of headwinds in recent years (e.g. headwinds to antibiotic volumes).

Derivation Summary

ELAN has a competitive position within the global animal health segment with a large, global footprint and scale that affords it competitive advantages relating to procurement, manufacturing, R&D, distribution and to buffer against the effects of customer consolidation. Compared to pharmaceutical peers that focus on humans, ELAN's portfolio benefits from no reimbursement risk. However, its antibiotic segment continues to face material headwinds from regulatory interventions and end-consumer preferences. ELAN's closest peer is Zoetis, Inc., which has a broader portfolio and has already achieved its debt reduction and margin expansion goals. ELAN's 'BB' IDR is multiple notches lower than the 'BBB' category and 'A' category ratings of its pharmaceutical peers due to significantly higher leverage, limited scale and weaker cash flow generation.

Parent-Subsidiary Linkage

The approach taken is a weak parent (Elanco Animal Health Incorporated)/strong subsidiary (Elanco US Inc.). Using its Parent and Subsidiary Linkage Rating Criteria, Fitch concludes there is open ring fencing and access & control. As such, Fitch rates the parent and subsidiary at the consolidated level with no notching between the two.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenues decline 5% to 8% in 2022 owing to supply-chain disruptions and pandemic-related headwinds, followed by mid-single-digit growth.

Operating EBITDA margins gradually improve during the forecast period assuming ELAN will realize $200 million of synergies in 2022 and focuses on other operating efficiency improvements.

Leverage declines well below 4.5x by YE 2023 through EBITDA expansion and debt reduction.

The issuer does not initiate a dividend nor engage in material M&A until it achieves its deleveraging target.

FCF generation of at least $600 million.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Successful execution of growth and productivity initiatives manifesting in revenues and margins consistent with management's forecast;

Fitch's expectation of gross leverage (gross debt to operating EBITDA) sustaining below 3.5x;

Fitch's expectation of FCF to gross debt sustaining above 10%;

Continued improvements in ELAN's scale and relative competitive position.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch's expectation of gross leverage sustaining above 4.5x due, in part, to weaker or slower recovery in EBITDA or synergy realization without additional debt repayment;

Continued erosion in antibiotic demand without sufficient offsets.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Principally Secured Capital Structure: ELAN is principally a secured debt borrower with a $750 million secured revolving credit facility and $4.9 billion secured term loans . The $1.1 billion of senior unsecured debt issued in 2018 remains outstanding.

Adequate Liquidity: Fitch expects ELAN will have adequate liquidity to manage through the current operating headwinds and upcoming debt maturities. At June 30, 2022, Elanco had $507 million in cash and cash equivalents and had $75 million drawn on its $600 million senior secured revolving credit facility. Fitch forecasts FCF will remain positive throughout the forecast period. The company has $40 million of debt maturing in 2022, $401 million in 2023, $50 million in 2024 and $300 million in 2025.

Debt Notching: Fitch does not employ a waterfall recovery analysis for issuers rated in the 'BB' category. The further up the speculative-grade continuum a rating moves, the more compressed the notching between the specific classes of issuances becomes. As such, Fitch rates the senior secured credit facility 'BBB-'/'RR1', two notches above the IDR. This rating illustrates Fitch's expectation for superior recovery prospects in the event of default given there is no structurally senior debt (e.g. an ABL) and leverage is not considered to be excessive.

The notching of ELAN's senior unsecured debt is rated 'BB'/'RR4'. The +0 notching from the IDR reflected the potential for being subordinated to secured debt and, thus, the secured debt issuances did not further subordinate the unsecured notes but instead was a realization of the assumption implicit in the original notching. Adequate Liquidity: Fitch expects ELAN will have adequate liquidity to manage through the current operating headwinds and upcoming debt maturities.

Issuer Profile

Elanco is the fourth largest animal health company, and it has one of the broadest portfolios of pet parasiticides in the companion animal sector. Elanco controls a diverse portfolio of more than 200 brands that make it a partner to veterinarians and food animal producers in more than 90 countries.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Elanco Animal Health Incorporated has an ESG Relevance Score of '4' for Customer Welfare - Fair Messaging, Privacy & Data Security due to regulatory interventions and end-consumer preferences away from the use of antibiotics in feed for animals. This has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

(C) 2022 Electronic News Publishing, source ENP Newswire