(ELAN) Possible Profits from Animal Health Spinoff

Eli Lilly's (LLY) IPO and eventual spin-off of its animal health care division, Elanco (ELAN), could be an interesting deal for special situation investors.

Industry & Company:

Zoetis (ZTS) management believes the animal health industry will continue its robust growth from the last five years as it grew from $26 Billion to $32 Billion at the end of last year, and will add another $9 Billion over the next 5 years. This equates to a GDP beating 5% annual growth rate. Even as threats of economic struggles approach the general economy – this industry, which splits revenues between meat production and pet health, should see its sales fairly resilient since families will likely continue eating meat, and buying medicine for their pets.

Elanco is a wholly-owned subsidiary of LLY. LLY is projecting ELAN to produce approximately $3B in revenue for 2018. This projection is in-line with previous years’ sales. ELAN has shown decent revenue growth, mostly through acquisition, as the industry consolidated. Even with very strong players in the industry, I would expect continued consolidation since no one company controls more than about 20% of industry sales.

Source: rocketfinancial.com

A quick glance over the prospectus shows the existing president of Elanco is staying on as CEO. A fair estimate of his age is about 51 based on graduating in 1989 from college. I think this is a good sign – he is still rather young and much of his total compensation will be in stock/options. It is a fairly complicated comp structure, at least for me, but his compensation seems to be aligned with future shareholders. I usually look for red-flags and I am not seeing any. I would love to hear other takes.

ELAN completed their issuing of debt, is performing their IPO this year, and anticipating the spinoff to LLY stockholders in 2019. The private placement of $2B debt issuance is comprised of $500 million at 3.912% due in August 2021, $750 million at 4.272% due in August 2023, and $750 million at 4.9% due August 2028. It appears the cash raised will be used to pay a cash dividend to LLY as part of the spinoff. The IPO, if completed, will raise approximately $1.4 billion by offering 62.9 million shares. A successful IPO would imply a market value of $7.7 billion, and combined with the debt offering places the standalone business at an enterprise value of ~9.9 billion according to Renaissance Capital.

Finally…. Valuation:

Recent history suggests independent animal health companies are strong when ran as separate entities. The chart below shows 5 year returns for comparable stocks and the S&P 500. Zoetis was IPO’d in 2013 and nearly tripled in the last 5 years, and IDEXX Labs has crushed the market by returning nearly 400% in the same time period.

Source: nasdaq.com

Looking past recent historical returns, I am basing my bull case on two market comps and one M&A transaction. For EV/EBITDA for ELAN, the multiples assume ELAN can achieve same EBITDA margins at ZTS and IDXX, respectively.

	ELAN	ZTS	IDXX	Merial/Sanofi Acq.
EV/S	3.3	8	9.5	-
EV/EBITDA	9 (ZTS)/ 12.5 (IDXX)	22	41	10
P/S	2.5	7.9	10	3

Taking all of this into consideration – I think what we have here is a bit of a ‘tweener’. The IPO should be closely in-line with a ‘take-private’ transaction, but if the stock re-rates to parameters as its large, public counterparts then this spinoff play could be a big payoff for investors. I am not taking any action at this time but will consider averaging into the typical spinoff price dynamics as holders of the ELAN sell their stake.