Value-creating activist gets involved with a pure play in the growing animal health market

Business: Elanco is an animal health company that develops, manufactures and markets products for companion and food animals. The company provides a range of parasiticide portfolios in the companion animal sector based on indications, species and formulations, with products that protect pets from worms, fleas and ticks. It also offers a pain and osteoarthritis portfolio across species, modes of action, indications and disease stages. It also provides treatments for otitis (ear infections), as well as cardiovascular and dermatology indications. Its portfolio in Food Animal Future Protein & Health category includes vaccines, nutritional enzymes and animal-only antibiotics. It also provides products in poultry and aquaculture production.

Stock Market Value: $14.4 billioin ($30.46 per share)

Percentage Ownership: 5.9%

Average Cost: $28.33

Activist Commentary: Sachem Head was founded in 2013 by Scott Ferguson, the first investment professional hired at Pershing Square where he worked for nine years. While Sachem Head has a history of solid value investing, their activism in their early years was short term and underwhelming at best. In their first campaign at Helen of Troy, they advocated for a sale of the company and share buybacks in a February 2014 letter and sold their entire position into the buyback a month later, something experienced activists never do. Their first 13D filing was on CDK Corp. only a month after the company went public through a spinoff – hardly giving management time to do anything. Since then, they have grown through campaigns at companies like Zoetis and Autodesk, partnering with more experienced investors like Pershing Square and Eminence. And recently, Ferguson has created value as a director of Olin, his first public company board seat in a portfolio company he did not invest in as part of a group. This investment in Elanco is his second of what we expect to be many in the future. Taking board seats signifies both commitment and contribution; and since their launch in 2013 Sachem Head has evolved from a value investor that used activism as a short-term stunt to a value investor that genuinely engages with companies to create value for shareholders.

On December 13, 2020, Sachem Head and the company entered into a cooperation agreement, pursuant to which the company appointed the following three individuals to the board as directors (i) William Doyle, executive chairman of Novocure Ltd., a publicly traded global oncology company commercializing a novel platform technology to treat solid tumors and former director of Zoetis, (ii) Scott Ferguson, the founder and managing partner of Sachem Head Capital Management and (iii) Paul Herendeen, EVP and CFO of Bausch Health and former EVP and CFO of Zoetis Inc. Sachem Head agreed to abide by customary voting and standstill provisions until the later of (x) five days after the date on which neither Ferguson nor any officer, director, consultant, partner or employee of Sachem Head continues to serve on the Board and (y) forty-five days before the closing of the non-proxy access shareholder director nomination window for the 2023 annual meeting.

Sachem Head took this position at a time when the company has been criticized for several missteps, including a poorly timed acquisition of Bayer AG’s animal-health assets for $6.9 billion that did not close until after the onset of the COVID pandemic. The company has also exhibited supply chain issues and low operating margins. Their EBITDA margin of about 18% is well below the 44% margin at Zoetis. Elanco has already announced a restructuring plan to create $100 million in annual savings and improve its margins but there is clearly a lot more that can be done. Prior to the pandemic, Elanco had been targeting a 31% EBITDA margin in 2022.

This situation is remarkably similar to the campaign Sachem Head did with Pershing Square at Zoetis in 2014. Both companies are one of a small number of pure play animal health companies. Both companies were spun-off from larger conglomerates within two years of the 13D filing (Zoetis/Pfizer and Elanco/Eli Lilly). This often results in a bloated infrastructure at the spun-off company, which could use the attention of an experienced activist to rein in. At Zoetis, margins improved from 29% to 44% today and resulted in a 45.69% return for Sachem Head versus 0.16% for the S&P 500 during the same time period. And now, both companies not only have activist directors, but some of the same people who created value at Zoetis. Aside from Ferguson, who orchestrated the activism at Zoetis along with Pershing Square, the two other new directors are William Doyle, the very same person that Sachem Head and Pershing Square put on the board of Zoetis, and Paul Herendeen, the former EVP and CFO of Zoetis when Sachem Head was involved there.

The other possibility here, but not likely the core opportunity is a sale of the company. Elanco is one of a few large, independent animal health companies and this type of company is very hard to build from scratch without brand equity and a broad portfolio. So, it could be interesting to a big pharma company that does not have an animal health business, and two years after its spinoff from Eli Lilly is enough of a waiting period for interested parties to acquire Elanco without any negative tax consequences.

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.