Based in Indiana, Elanco Animal Health (ELAN 1.31%) develops products and services that treat diseases in pets and commercial animals around the world. Just two short years after being spun off from Eli Lilly, Elanco has taken a bold step by acquiring Bayer Animal Health in a $7.6 billion move that establishes it as the second-largest animal health company in the world by revenue (behind Zoetis).

A $7.6 billion animal-health merger

The deal was announced in August 2019 and was financed with $5.2 billion in cash and 72.9 million shares of Elanco. Management believes Bayer will help it strengthen its focus on the connections between pet health and farm animal health, as well as providing new research and development capabilities that will help expand the portfolio of pet and farm products and generate future cash flow growth.

The deal will triple Elanco's international footprint, and that greater scale should help the combined company cut better distribution agreements and allow it to reach more customers.

Finally, adding Bayer increases Elanco's exposure to the pet health market to 50% of its total revenue. While both companies serve pets and livestock alike, the pet health market is more attractive because it is higher-margin and is growing faster. If investors see this acquisition as making Elanco into more of a play on the pet-health market, its valuation multiple could rise.

Dog on exam table with pink tape on paw at veterinary office

Image Source: Getty Images.

Financial outlook for the combined company

The negative effects of COVID-19 have made 2020 a tough year for the animal health market. The coronavirus outbreak disrupted the food supply chain, leading farmers to reduce spending on livestock due to a lack of demand from restaurants and meat processing facilities. However, the pet health market has been relatively stable. The net impact for Elanco has been a 25% decrease in revenue compared to 2019.

Management believes the acquisition of Bayer will result in improved margins, predicting that gross margin will rise to 60% by 2022 from 52% in 2019. The increase will be driven by $300 million in cost synergies, increased sales of higher-margin pet products, and operating leverage from revenue growth, which management believes will also accelerate at a rate in the mid-single digits.

Besides a greater focus on the pet market, the rise of e-commerce in selling pet health products should boost Elanco's returns. Selling online will provide Elanco better access to the nearly one-third of pet owners who do not regularly visit a veterinarian. Finally, the combined R&D resources of Elanco and Bayer are expected to result in an increased pace of product development, which should result in more products to sell.

Overall, a combined Elanco and Bayer should be able to produce faster growth and higher margins, which should accrue to shareholder value. This could make Elanco an ideal animal healthcare stock to own in the coming years.