Severely Undervalued Animal Health Stock

One of the most successful investment strategies historically involve buying stocks of companies that are significantly undervalued relative to fair value.

 

This approach, used by the likes of Benjamin Graham and Warren Buffett, has reliably produced market-beating gains in all kinds of macroeconomic environments.

 

The problem, however, is finding such undervalued securities. One stock that appears to fall into this category in today’s market is Elanco Animal Health (NYSE:ELAN). 

Elanco Animal Health manufactures animal pharmaceuticals for both pets and livestock. Included in the company’s portfolio of products are flea and tick treatments, pain medications and cardiovascular treatments.

 

The company’s livestock brands offer parasite treatments, vaccines and other essential pharmaceuticals for poultry, swine, cattle and aquaculture.

 

In Q3, Elanco generated $1.028 billion in total revenue. This represented a 9 percent reduction in revenue from the same period in 2021. The pet health segment declined 11 percent, while farm business lines declined 7 percent. Much of this decline was due to unfavorable currency conditions, but there was still an organic drop in sales relative to the prior year.

 

Despite difficulties keeping up with revenue, Elanco’s adjusted quarterly earnings of $0.20 per share did beat the consensus estimate of $0.16. This points to solid management execution and cost controls, as Elanco has managed to remain profitable during a difficult period for its business.

 

In terms of future growth, Elanco may be supported by two factors. The first is the growing trend of spending on pets. Americans today are spending more on their pets’ healthcare than ever before, and this trend does not seem to be in danger of reversing. Elanco is also continuing to spend on R&D, giving it a pipeline of potentially profitable new products that will arrive on the market in the coming years.

 

Despite potentially favorable long-term conditions, Elanco is not expected to perform particularly well in earnings growth in the short to medium term.

 

In the coming year, the company’s earnings are expected to drop slightly to $1.01 per share. On the 5-year horizon, Elanco’s earnings are projected to grow at a compounded rate of just 3.3 percent. This largely rules Elanco out as a growth stock, but the valuation of the company still makes it a rather attractive investment.

 

Elanco appears to have considerable upside potential. Analysts forecast a price of $17 per share, about 32 percent above current levels. Discounted cash flow analysis suggests an ever higher fair value of $20.06, which would represent an upside of over 55 percent.

 

Elanco’s price-to-earnings and price-to-book ratios further support the argument for undervaluation. The stock currently trades at 12.7 times earnings, well below the S&P 500 average of 21.9.

 

At 0.91, Elanco is also priced at a slight discount to its book value. As such, Elanco could see its stock price move considerably higher in an eventual correction toward its fair value.

 

It’s also worth considering the fact that Elanco’s price-to-sales ratio has dropped well below its recent historical average. The stock currently trades at 1.35 times sales. Until the middle of 2022, the stock reliably traded at 2-3 times overall sales.

 

One of the risk factors Elanco faces is its relatively low projected earnings growth. While the stock is attractively priced in comparison to its earnings, there doesn’t appear to be much room for those earnings to rise in the near future. This could be a concern for the stock on a long-term basis, but the company could also make future changes that reignite earnings growth.

 

Elanco also has a relatively high debt load for a business that is not slated for high future growth. The company’s debt-to-equity ratio is currently 0.82, which is above what is generally considered a safe level. This detracts somewhat from the value argument for the company. Given the discrepancy between probable fair value and the current trading price, however, the debt load alone is not high enough to disqualify Elanco as a good investment.

 

Finally, Elanco has a very low degree of insider ownership. At the time of this writing, under 1 percent of the company was owned by inside investors.

 

Over the past 12 months, multiple insiders have pared their holdings in the company. While this is not an inherent risk, it does indicate that key executives and directors could be bearish on Elanco’s future stock performance.

 

While Elanco may not have enormous growth potential, the stock is currently priced at a level that makes it something of a natural fit for value investors. It may take some time for the stock’s price to rise closer to its fair value, but the returns that could be seen if such an upwards correction takes place would likely make it a worthwhile investment.

 

Elanco also has an economic moat as an established provider of essential animal health products. Although it is not immune from competition, the company is reasonably well entrenched and does not seem likely to lose its position in the market anytime soon. Elanco’s livestock-oriented business lines are also stable sources of revenue that will likely perform well under a variety of market conditions.

 

Although Elanco does have risks associated with low growth prospects and debt, they are far from sufficient to overrule the value argument for the stock. Even if earnings drop slightly or remain flat, Elanco will likely produce at least decent returns for investors. As such, the stock likely represents an asymmetrical risk proposition.

 

Ultimately, Elanco makes a good deal of sense for relatively conservative value investors. Barring unexpected reductions in earnings or market disruptions, the stock’s undervaluation will likely make it a good long-term performer for those who buy at today’s prices.

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