Shares of this animal health company fell after the announcement of its recent acquisition, but it appears that was an overreaction. Barclays just upgraded the company’s stock to ‘Overweight’.
Elanco Animal Health Incorporated (ELAN)
From Argus Weekly Staff Report
Elanco Animal Health Incorporated (ELAN) is a leading animal health company. This well-managed company, a September 2018 spinoff from Eli Lilly, makes health and nutrition products for both companion and food animals. Founded in 1954, Elanco has a record of consistent growth and has tripled in size over the past ten years.
As part of its current ‘three-pillar’ growth strategy, the company is focusing on portfolio development, innovation, and productivity improvements, as well as strengthening its targeted growth categories of Companion Animal Disease Prevention, Companion Animal Therapeutics, and Food Animal Future Protein & Health.
The company recently announced an agreement to acquire Bayer’s animal health business for $7.6 billion in a deal that management expects will double the size of its fast-growing animal health business and become accretive in the first full year following its close. While there are some concerns over the fact that Elanco will become highly leveraged as a result of this deal (likely reaching a gross debt to adjusted EBITDA leverage ratio of 5-times, up from its current 3.7-times), we believe that the market’s reaction to this news was overly pessimistic given the company’s strong cash flow generation abilities and the addition of Bayer’s strong e-commerce and retail expertise. We also note that the deal is unlikely to close before mid-2020. Until then, we expect for Elanco to continue to improve its margins as it improves its productivity, and we look for further geographic expansion of its existing products and additional pipeline approvals.
We are encouraged by management’s continued ability to increase margins and expect comparisons to improve as we move into 2020. As such, we are maintaining our 2019 adjusted EPS estimate of $1.10. In 2020, we expect that the company will experience significant revenue growth upon the completion of its acquisition of Bayer’s animal health unit, but note that the company’s margins will likely experience short-term pressures as it integrates the business. Our 2020 estimate is $1.28.
ELAN shares appear attractively valued at current prices, below the midpoint of their post-IPO range of $25-$38. The shares are trading about 11% below their 50-day moving average and 13% below its 200-day average, having formed a ‘death cross’ on August 28. But on the same day, the stock seemed to find support around $25.50, and has advanced about 7.5% since then. The relative strength index (RSI) of 44 suggests that the stock could run significantly higher before running out of steam. While we expect that the stock will continue to regain its value over the next 12 months, we note that it faces initial resistance levels around $28, $29, and $30, with more significant resistance at $31.
To value the stock on a fundamental basis, we use peer and historical multiple comparisons, as well as a discounted cash flow model. At current prices, the shares are trading at 24.8-times our 2019 EPS estimate, well below the 33.3-times consensus earnings for its largest competitor Zoetis and below its five-year historical average of 29.6. It is also trading at a price/book multiple of 1.9, below Zoetis’ 25.4. Given the company’s growth potential, cost-cutting efforts, and recent M&A activity, we believe that Elanco has the potential for positive earnings surprises and that the shares warrant a premium valuation.
We also believe that the stock’s recent valuation discount, due in part to leverage ratio fears over the company’s acquisition of Bayer’s animal health business, are excessive given the relatively fast estimated accretion of the deal and the long-term growth opportunities that it can afford to Elanco. Our revised target price of $31, lowered from $36, implies a multiple of 28.2-times our 2019 EPS estimate, still below the company’s historical average, and a potential gain of about 13% from current levels.
Jim Kelleher, CFA, Argus Weekly Staff Report, www.argusresearch.com, 212-425-7500, September 20, 2019