Business: Elanco is one of the largest global animal health pharmaceutical companies, developing and marketing products for both pet health and farm animals. It offers pet health disease prevention products, such as parasiticide and vaccine products that protect pets from worms, fleas, and ticks under the Seresto, Advantage, Advantix, and Advocate brands; pet health therapeutics for pain, osteoarthritis, ear infections, cardiovascular, and dermatology indications in canines and felines under the Galliprant and Claro brands; vaccines, antibiotics, parasiticides, and other products for use in poultry and aquaculture production, as well as functional nutritional health products, including enzymes, probiotics, and prebiotics; and a range of vaccines, antibiotics, implants, parasiticides, and other products used in ruminant and swine production under the Rumensin and Baytril brands.

Stock Market Value: $15.6B ($33.15 per share)

Percentage Ownership:  1.61%

Average Cost: n/a

Activist Commentary: Starboard is a very successful activist investor and has extensive operational activism experience helping boards and management teams run companies more efficiently and improving margins. They have made 103 13D filings. In those 103 filings, they have averaged a return of 33.9% versus 13.3% for the S&P500. Their average 13D hold time is 18 months.

On Oct. 6, 2021, Starboard expressed its belief that Elanco Animal Health Inc (ELAN) has an opportunity to raise margins through operational improvements.

Elanco was spun out of Eli Lilly in September 2018 and was met with a lot of excitement – in its first day of trading, the stock closed +50%. The reason why the stock was received so well was because management publicized opportunities to grow revenue at or above industry growth rates and to improve margins by approximately 1,000 basis points over five years. In 2018, Elanco’s EBITDA margins were 21% versus 38% for Zoetis, its closest peer. Further, Zoetis was a relevant case study for Elanco as it was also spun out from a larger company and management was able to execute on its value creation plan, resulting in Zoetis’ stock price outperforming the S&P500 by 330% since its IPO.

Elanco management targeted 31% EBITDA margins by 2023. The company’s management made it seem as though its strategy would not be dependent on other large deals and that it would be focused on executing on its own pipeline. However, on Aug. 20, 2019, Elanco announced the acquisition of Bayer’s Animal Health business for approximately $7.6 billion, which surprised the market and sent the stock down 24%. Elanco explained this acquisition as it being too good of an opportunity to pass up as it would significantly expand scale and change the mix of the business. As a result, management accelerated the timeline of its margin target goal by a year and announced that because of this acquisition they would reach their goal of 31% EBITDA margins by 2022.

Post-acquisition, Elanco and Zoetis had a closer scale and more similar geographic/portfolio mixes, but, Elanco’s (including Bayer) margins were well below Zoetis, which had EBITDA margins of 40% by 2019. Granted, that Zoetis had some valuable products with high pricing power leading to higher gross profit margins than Elanco, but that is why Elanco was not targeting 40% but only 31%. But then, in 2020, management revised its guidance and stated that it was now hoping to achieve 31% EBITDA margins by 2024, a year later than even its first projection and two years later than its last projection.

To confuse and frustrate shareholders even more, management has claimed that they have realized significant cost savings, but this is not resulting in margin expansion. Instead, the gap between Elanco and Zoetis remains: 2,455 basis points in 2020 and 2,086 basis points estimated for 2021. This had resulted in a lack of confidence in management’s execution, an underperforming stock price and a large margin and multiple gap with Zoetis trading at 26x 2022E EBITDA and Elanco trading at 18x. This gap can be closed through improved operational execution, which will inspire greater confidence from shareholders, and lead to an improved valuation multiple. Starboard’s analysis estimates a $47 stock price for Elanco with 31% EBITDA margins and no multiple improvement and a $74 stock price with 31% EBITDA margins and a multiple equal to Zoetis. With even better margin improvement to 37.1%, Starboard sees a potential $91 stock price.

It is important to note that Starboard is not the only activist in Elanco. In October 2020, Sachem Head filed a 13D on Elanco. In December 2020, the firm settled with Elanco for three board seats for Scott Ferguson, Paul Herendeen and William Doyle. Starboard has given the company some time to execute with these new directors and will likely give it more time, but at some point the board and management have to show they can execute. Starboard is not the only shareholder who is clearly frustrated. At last year’s annual meeting, there were significant votes cast against each director up for election – Art Garcia (46.34%), Denise Scots-Knight (46.54%), Jeffrey Simmons (37.04%) and William Doyle (21.09%).

Elanco has a huge opportunity to create shareholder value through margin improvement, and Starboard has extensive experience in improving margins of portfolio companies from the board level. Starboard cannot make director nominations until January 2022, but this seems like a logical situation for an invitation on the board for Starboard so hopefully it will not come to that.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Elanco is owned in the fund.