What happened
Shares of Elanco Animal Health (ELAN -4.57%) tumbled 21.1% last month, according to data from S&P Global Market Intelligence. The animal health giant reported second-quarter and first-half 2019 operating results that reflected the headwinds in global livestock markets, although operating margins improved thanks to lower cost of goods sold.
A week after announcing quarterly earnings, Elanco Animal Health announced it had agreed to acquire the animal health business of Bayer for a massive $7.6 billion. The transaction promises to strengthen the company's high-margin companion animal portfolio and push its contributions to roughly 50% of revenue, compared to just 38% today. Investors balked at the acquisition price, which will be paid with 70% cash (debt and, confusingly, stock) and 30% stock.
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So what
African swine fever has decimated hog populations in Asia, although cattle and poultry markets have shown weakness, too. That's hurt Elanco Animal Health because 62% of total revenue comes from products aimed at livestock. The remaining 38% is generated from the higher-margin companion animal portfolio.
As a result, Elanco Animal Health grew revenue just 0.4% in the first half of 2019 compared to the year-ago period. Operating income soared 153% in that span, but at just $95 million, first-half 2019 operating margin stood at just 6.3%.
Given that, investors can see the rationale behind the acquisition of Bayer's animal health business. But Elanco Animal Health is valued at just $10 billion, which makes a $7.6 billion acquisition quite a large pill to swallow.
Now what
Shares of Elanco Animal Health have now lost 24% since the initial public offering. That heightens the pressure on management to prove that the acquisition makes good financial sense and that it will pay off for shareholders.
On paper, a larger companion animal portfolio should drive higher margin growth. But the struggling livestock portfolio will get larger, too, and global economic headwinds suggest now may be an awful time to take on billions in debt. If the projected cash flow generation doesn't materialize, then Elanco Animal Health could find itself in a regrettable position.
