# Elanco Animal Health Inc (ELAN) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Elanco Animal Health Inc's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1739104/000173910423000004/elan-20221231.htm
Accession: 0001739104-23-000004
Filing date: 2023-03-01
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

Company profile: /company/ELAN/
All MD&A years: /company/ELAN/mda/
Previous year: /company/ELAN/mda/fy2021/ (FY 2021)
Next year: /company/ELAN/mda/fy2023/ (FY 2023)

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

Introduction

Management’s discussion and analysis of financial condition and results of operations (MD&A) is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operations and financial position. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Form 10-K. Certain statements in this Item 7 of Part II of this Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements. For results of operations discussions related to years ended December 31, 2021 and 2020, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the Securities and Exchange Commission on February 28, 2022.

Overview

Elanco is a global animal health company that develops products for pets and farm animals in more than 90 countries. With a heritage dating back to 1954, we rigorously innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable, and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in two primary categories: pet health and farm animal.

On August 27, 2021, we acquired KindredBio, a biopharmaceutical company that developed innovative biologics focused on saving and improving the lives of pets. We had previously signed an agreement with KindredBio in the second quarter of 2021 to acquire exclusive global rights to KIND-030, a monoclonal antibody in development for the treatment and prevention of canine parvovirus. The acquisition of KindredBio further accelerates our opportunity for expansion in pet health, notably by expanding our research efforts in dermatology. See Note 6: Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of KindredBio

On August 1, 2020, we completed the acquisition of Bayer Animal Health. The acquisition expanded our pet health product category, advancing our planned portfolio mix transformation and creating a better balance between our farm animal and pet health product categories. Our product portfolio and pipeline have been enhanced by the addition of Bayer Animal Health, which complements our commercial operations and international infrastructure. See Note 6: Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of Bayer Animal Health.

We offer a diverse portfolio of approximately 200 brands that make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors and independent retailers, and directly to farm animal producers and veterinarians. With the acquisition of Bayer Animal Health, we have expanded our presence in retail and e-commerce channels, allowing our customers to shop where and how they want.

A summary of our 2022, 2021 and 2020 revenue and net loss is as follows:

[[GREPCENT_TABLE]]
[["","Year Ended December 31,"],["","2022","","2021","","2020"],["Revenue","$","4,411","","","$","4,764","","","$","3,271"],["Net loss","(78)","","","(483)","","","(574)"]]
[[/GREPCENT_TABLE]]

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[["","47"]]
[[/GREPCENT_TABLE]]

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As a global company, significant portions of our revenue and expenses are recorded in currencies other than the U.S. dollar. Accordingly, in any period, our reported revenue, expenses and resulting earnings (loss) are impacted by changes in the exchange rates of those currencies relative to the U.S. dollar.

Increases or decreases in inventory levels in our distribution channels can positively or negatively impact our quarterly and annual revenue results, leading to variations in revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, blackout shipping periods due to system downtime, implementations and integrations, and procedures and environmental factors beyond our control, including weather conditions and the COVID-19 global pandemic.

Key Trends and Conditions Affecting Our Results of Operations

Industry Trends

The animal health industry, which includes both pets and farm animals, is a growing industry that benefits billions of people worldwide.

We believe that factors influencing growth in demand for pet medicines and vaccines include:

•increased pet ownership globally;

•pets living longer; and

•owners sharing a unique and loving bond with their pets.

As demand for animal protein grows, farm animal health is becoming increasingly important. We believe that factors influencing growth in demand for farm animal medicines and vaccines include:

•two in three people needing improved nutrition;

•increased global demand for protein, particularly poultry and aquaculture;

•natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production;

•loss of productivity due to farm animal disease and death;

•increased focus on food safety and food security; and

•human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization.

Growth in farm animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity.

Factors Affecting Our Results of Operations

Global Macroeconomic Environment

Our operations are conducted globally, and we are exposed to and are impacted by various global macroeconomic factors. Global economic conditions continue to create uncertainty, most notably due to the Russia-Ukraine conflict, the COVID-19 pandemic, supply chain disruptions, and rising inflation. Continued evolution of these conditions has led to economic slowdowns in certain countries and/or regions. It has also led to volatility in consumer behavior, which has reduced demand due to consumption decreases and retailer destocking, particularly impacting our parasiticide products. We expect these global macroeconomic factors to continue in 2023.

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[["","48"]]
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Russia-Ukraine Conflict

In February 2022, Russia commenced military action against Ukraine. In response, the U.S. and certain other countries imposed and continue to impose significant sanctions and export controls against Russia, Belarus and certain individuals and entities connected to Russian or Belarusian political, business, and financial organizations. The U.S. and certain other countries could impose further sanctions, trade restrictions, and other retaliatory actions if the conflict continues or worsens. The broader consequences of the conflict, including related inflationary pressures, geopolitical tensions, additional retaliatory actions taken by the U.S. and other countries, and any counter retaliatory actions by Russia or Belarus in response, including, for example, potential cyberattacks or the disruption of energy and commodity exports, are likely to cause regional instability and could materially adversely affect global trade, currency exchange rates, regional economies and the global economy. The situation remains uncertain and it is difficult to predict the impact that the conflict and actions taken in response to the conflict will have on our business; however, they could increase our costs, disrupt our supply chain, reduce our sales and earnings, or otherwise adversely affect our business and results of operations.

As a global animal health leader, we have an obligation to support the health of animals and people. At the center of that work is ensuring access and availability of food and avoiding the spread of disease. At this time, we are limiting our business in Russia to only the essential products that support these needs, while complying with all imposed sanctions. We do not currently manufacture products or source any materials from companies in Russia for use in our products, but that could change because of new laws requiring products sold in Russia to be produced there as well. We do not conduct business with the Russian government. During the year ended December 31, 2022, revenue to Russian and Ukrainian customers represented approximately 2% of our consolidated revenue. Assets held in Russia as of December 31, 2022 represented less than 1% of our consolidated assets.

COVID-19 Pandemic

We continue to closely monitor the impact of the COVID-19 pandemic, including its variants, and the related economic effects on all aspects of our business, including impacts on our operations, supply chain, and customer demand. The extent to which the COVID-19 pandemic may impact our financial condition and results of operations remains uncertain and is dependent on developments that are out of our control, including a resurgence in positive cases, the emergence of new variants, governmental actions in response to the pandemic (for example, the lockdown orders in China that were lifted in late 2022), and the successful administration of effective vaccines and boosters. We cannot predict the impact that the ongoing COVID-19 pandemic will have on our employees, customers, vendors and suppliers; however, the COVID-19 pandemic has had and may continue to have an adverse impact on our business.

Supply Chain

We continue to experience disruption and volatility in our global supply chain network. This disruption, combined with increased demand for key raw materials and labor constraints, has also impacted our suppliers, resulting in shortages of raw materials and components required to manufacture our products. We continue to work closely with suppliers and freight partners to mitigate impacts to our operations and customers, including the addition of new transportation routes, targeted increases of certain safety stocks, and alternative sources of materials. Although we regularly monitor the financial health of companies in our supply chain, prolonged financial hardship on our suppliers and labor shortages could continue to disrupt our ability to obtain key raw materials, adversely affecting our operations. The global industry freight environment has experienced, and could continue to experience, lead time disruptions and high shipping costs, negatively impacting our profitability.

Inflation

We are experiencing, and expect to continue to experience, inflationary pressures due to, among other things, the geopolitical events and macroeconomic factors noted above. Increased inflation rates primarily impact us by increasing our costs, including raw materials, labor, energy, transportation, and other input costs, adversely affecting our profit margins, operating results, and cash flows. In response to these inflationary costs, we have implemented price increases and may implement additional price increases in the future.

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[["","49"]]
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Revision of Prior Period Financial Statements Primarily Relating to Tax Valuation Allowance Adjustment

In connection with the preparation of our financial statements as of and for the year ended December 31, 2022, a cumulative error was identified relating to the valuation allowance for taxes for a Southeast Asia affiliate. While immaterial to prior years, correcting this cumulative error in 2022 would have caused the 2022 financial statements to be materially misstated. Therefore, immaterial revisions in relation to this item were made to our financial statements as of and for the years ended December 31, 2021 and 2020. The correction of this error was immaterial to our financial statements for those years.

As a result of having to make the revisions related to this error, we made other immaterial revisions to the consolidated financial statements as of and for the years ended December 31, 2021 and 2020. All of the revisions are reflected throughout this Form 10-K. See Note 2: Revision of Previously Issued Consolidated Financial Statements to the consolidated financial statements for additional information.

Acquisitions of Bayer Animal Health and KindredBio

We have incurred expenses in connection with our acquisitions of Bayer Animal Health and KindredBio, including fees for professional services such as legal, accounting, consulting, and other advisory fees and expenses. Expenses incurred in 2022 and 2021 are primarily related to integration activities. In addition, we have incurred and expect to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics and to expand administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by the former parent company of Bayer Animal Health. We anticipate that these additional costs will be partially offset by expected synergies. The ERP system integration of legacy Bayer Animal Health to the Elanco system is expected to be completed early in the second quarter of 2023. As a result, there may be a timeframe during which inventory shipments cannot occur. In response to this, we have built some additional inventory as of December 31, 2022 and expect to continue to increase our inventories on hand to ensure that our product is available to customers. Alternatively, we anticipate that certain customers may modify purchasing habits, which would cause a shift of revenue from the second quarter to the first quarter of 2023. In addition, we started extending payment terms in 2023 and may need to continue to extend payment terms to certain customers depending on the estimated timeframe during which shipments cannot occur and based on geography.

Product Development and New Product Launches

A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depend on both our pipeline of new products, including new products that we develop internally and may develop through joint ventures and products that we are able to obtain through licenses or acquisitions, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization.

Competition

We face intense competition. Principal methods of competition vary depending on the particular region, species, product category, or individual product. Some of these methods include product quality, price, cost-effectiveness, promotional effectiveness, new product development and product differentiation. Certain products, both existing and new products that we introduce, may compete with other branded or generic products already on the market or that are later developed by competitors. See "Item 1. Business — Competition."

Productivity

Our results during the periods presented have benefited from operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds.

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[["","50"]]
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Our acquisitions in the six years prior to the acquisition of Bayer Animal Health added, in the aggregate, $1.4 billion in revenue, 4,600 full-time employees, and 12 manufacturing and eight R&D sites. The acquisitions of Bayer Animal Health on August 1, 2020 and KindredBio on August 27, 2021 added 3,950 full-time employees, 10 manufacturing sites, and five R&D sites (before company-wide restructuring activities initiated in 2020 and 2021). In addition, from 2015 to 2022, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across the manufacturing, R&D and marketing, selling and administrative functions. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing and selling manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities through alternate sources of supply. Additional cost savings have resulted from reducing the number of R&D sites, sales force consolidation and reducing discretionary and other general and administrative operating expenses.

Foreign Exchange Rates

Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the years ended December 31, 2022 and 2021, approximately 51% of our revenue was denominated in foreign currencies. As we operate in multiple foreign currencies, including the Euro, British pound, Swiss franc, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements decreased revenue by approximately 4% during the year ended December 31, 2022. Currency movements increased revenue by approximately 1% and decreased revenue by approximately 1% during the years ended December 31, 2021 and 2020, respectively.

Components of Revenue and Costs and Expenses

Revenue

Our revenue is primarily derived from a diversified portfolio of products across species consisting of dogs and cats (collectively, pet health) and cattle, poultry, swine and aqua (collectively, farm animal). We market our products to veterinarians, pet owners, and farm animal producers, then sell directly or indirectly through third-party distributors, retailers, or e-commerce outlets. For additional information regarding our products, including descriptions of our product categories, see "Item 1. Business — Commercial Operations" and "Item 1. Business — Products."

Costs, Expenses and Other

Cost of sales consists primarily of cost of materials, facilities and other infrastructure used to manufacture our products, shipping and handling, inventory losses and expired products.

R&D expenses consist of project costs specific to new product R&D and product lifecycle management, overhead costs associated with R&D operations, regulatory, product registrations and investments that support local market clinical trials for approved indications. We manage overall R&D based on our strategic opportunities and do not disaggregate our R&D expenses incurred by nature or by product as we do not use or maintain such information in managing our business.

Marketing, selling and administrative expenses consist of, among other things, the costs of marketing, promotion and advertising and the costs of administration (business technology, facilities, legal, finance, human resources, business development, external affairs and procurement).

Amortization of intangible assets consists of the amortization expense for intangible assets that have been acquired through business combinations and other business development arrangements.

Asset impairment, restructuring and other special charges consist primarily of severance costs resulting from actions taken as part of our productivity initiatives and to reduce our costs; long-lived asset impairment charges and write-downs primarily related to product rationalizations, site closures, the sale of manufacturing sites; transaction

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and integration costs from acquired businesses and other related expenses, primarily Bayer Animal Health; costs associated with the acquisition of KindredBio; and costs related to the build out of processes and systems to support finance and global supply and logistics, among others.

Interest expense, net of capitalized interest consists of interest incurred on our debt.

Other (income) expense, net consists primarily of various items including net (gains)/losses on asset disposals, realized and unrealized foreign exchange translation (gains)/losses, (gains)/losses on equity investments, and loss or impairment on other investments.

Comparability of Historical Results

Our historical results of operations for the periods presented may not be comparable with prior periods or with our results of operations in the future due to many factors, including but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations."

Results of Operations

The following discussion and analysis of the consolidated statements of operations should be read along with the consolidated financial statements and the notes thereto included elsewhere in this report. For more information, see Note 3: Basis of Presentation to the consolidated financial statements.

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[[/GREPCENT_TABLE]]

Certain amounts and percentages may reflect rounding adjustments.

NM - Not meaningful

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Disaggregated Revenue

On a global basis, our revenue by product category for the years ended December 31 is summarized as follows:

[[GREPCENT_TABLE]]
[["","","Revenue","","% of Total Revenue","","% Change"],["(Dollars in millions)","","2022","","2021","","2020","","2022","","2021","","2020","","22/21","","21/20"],["Pet Health","","$","2,138","","","$","2,350","","","$","1,356","","","48","%","","49","%","","41","%","","(9)%","","73%"],["Farm Animal","","2,219","","","2,332","","","1,835","","","50","%","","49","%","","56","%","","(5)%","","27%"],["Subtotal","","4,357","","","4,682","","","3,191","","","99","%","","98","%","","98","%","","(7)%","","47%"],["Contract Manufacturing (1)","","54","","","82","","","80","","","1","%","","2","%","","2","%","","(34)%","","3%"],["Total","","$","4,411","","","$","4,764","","","$","3,271","","","100","%","","100","%","","100","%","","(7)%","","46%"]]
[[/GREPCENT_TABLE]]

Note: Numbers may not add due to rounding

(1)Represents revenue from arrangements in which we manufacture products on behalf of a third party, including supply agreements associated with divestitures of products related to the acquisition of Bayer Animal Health.

On a global basis, the effect of price, foreign exchange rates and volumes on changes in revenue as compared to the prior year was as follows:

[[GREPCENT_TABLE]]
[["Full year 2022(Dollars in millions)","","","","","","Revenue","","Price","","FX Rate","","Volume","","Total","","CER (1)"],["Pet Health","","","","","","$","2,138","","","2%","","(4)%","","(7)%","","(9)%","","(5)%"],["Farm Animal","","","","","","2,219","","","2%","","(5)%","","(2)%","","(5)%","","\u2014%"],["Subtotal","","","","","","4,357","","","2%","","(4)%","","(5)%","","(7)%","","(2)%"],["Contract Manufacturing","","","","","","54","","","\u2014%","","(4)%","","(29)%","","(34)%","","(29)%"],["Total","","","","","","$","4,411","","","2%","","(4)%","","(5)%","","(7)%","","(3)%"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["Full year 2021(Dollars in millions)","","Revenue","","Price","","FX Rate","","Volume (2)","","Total","","CER (1)"],["Pet Health","","$","2,350","","","4%","","1%","","68%","","73%","","72%"],["Farm Animal","","2,332","","","\u2014%","","1%","","26%","","27%","","26%"],["Subtotal","","4,682","","","2%","","1%","","44%","","47%","","46%"],["Contract Manufacturing","","82","","","\u2014%","","\u2014%","","3%","","3%","","3%"],["Total","","$","4,764","","","2%","","1%","","43%","","46%","","45%"]]
[[/GREPCENT_TABLE]]

Note: Numbers may not add due to rounding

(1)Constant exchange rate (CER), a non-GAAP measure, is defined as revenue growth excluding the impact of foreign exchange. The calculation assumes the same foreign currency exchange rates that were in effect for the comparable prior-year period were used in translation of the current period results. We believe this metric provides a useful comparison to previous periods.

(2)Impact of 2021 revenue from Bayer Animal Health is reflected in volume.

Revenue

Pet Health revenue decreased by $212 million or 9%, driven by a decrease in volume and an unfavorable impact from foreign exchange rates, partially offset by an increase in price. On a constant currency basis, the decrease of 5% was primarily attributable to lower demand as a result of increased competition impacting certain parasiticide products as well as the overall deterioration in global macroeconomic conditions, which particularly impacted sales of over-the-counter U.S. parasiticide products. The impact was partially offset by growth in our global pain portfolio.

Farm Animal revenue decreased by $113 million or 5%, driven by an unfavorable impact from foreign exchange rates and a decrease in volume, partially offset by an increase in price. On a constant currency basis, revenue was flat year over year. Growth driven by increased demand for aqua products and the contribution from innovation was offset by a continued decline in swine, particularly driven by market conditions in Asia and to a lesser extent competition in Europe, as well as the impact of generic competition for certain cattle brands and the impact of supply chain disruptions.

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Contract Manufacturing revenue decreased by $28 million to $54 million and represented 1% of total revenue.

Cost of Sales

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[[/GREPCENT_TABLE]]

Cost of sales as a percentage of revenue decreased in 2022 as compared to 2021 primarily due to amortization of the fair value adjustment of $64 million recorded from the acquisition of Bayer Animal Health in 2021. Excluding the $64 million fair value adjustment for the year ended December 31, 2021, cost of sales as a percentage of revenue would have been approximately 43%, consistent with 2022. Cost of sales decreased in 2022 primarily due to lower revenue, improvements in manufacturing productivity and the impact of foreign exchange, partially offset by inflationary impacts on input costs, freight, and conversion costs as well as unfavorable product mix.

Research and Development

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[[/GREPCENT_TABLE]]

R&D expenses decreased $48 million to $321 million in 2022 as compared to 2021. R&D expenses in the current year were favorably impacted by cost savings realized as a result of 2021 restructuring activities, lower professional services costs due the rationalization of certain R&D projects, and the impact of foreign exchange.

Marketing, Selling and Administrative

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[[/GREPCENT_TABLE]]

Marketing, selling and administrative expenses decreased $138 million in 2022 compared to 2021, primarily driven by disciplined cost management across the business, cost savings realized as a result of 2021 restructuring activities, a decrease in advertising and promotional costs, and the impact of foreign exchange, partially offset by increases in legal expenses during the period.

Amortization of Intangible Assets

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[["","","Year Ended December 31,","","% Change"],["(Dollars in millions)","","2022","","2021","","2020","","22/21","","21/20"],["Amortization of intangible assets","","$","528","","","$","556","","","$","360","","","(5)","%","","54","%"]]
[[/GREPCENT_TABLE]]

Amortization of intangible assets decreased $28 million to $528 million in 2022 as compared to 2021, primarily due to the impact of foreign exchange rates.

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[["","54"]]
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Asset Impairment, Restructuring and Other Special Charges

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

For additional information regarding our asset impairment, restructuring and other special charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Asset impairment, restructuring and other special charges decreased $451 million to $183 million in 2022 as compared to 2021, due in part to a $177 million year over year decrease in severance charges and overall acquisition-related expenses. Also contributing to the decrease were certain nonrecurring charges recorded during 2021, including a $279 million charge to write down assets at our Shawnee and Speke manufacturing sites that were classified as held for sale to an amount equal to fair value less costs to sell, $66 million of impairment charges for intangible assets that were subject to product rationalization, a $26 million charge to establish a liability for future royalty and milestone payments relating to our canine parvovirus license agreement with KindredBio, and an $8 million charge related to a litigation settlement for a matter that originated prior to our acquisition of Bayer Animal Health. These decreases were partially offset by $29 million of nonrecurring pension curtailment gains recorded during 2021 as well as a $22 million asset write-down charge recorded upon the final sale of our Speke manufacturing site and a one-time charge of $59 million related to the expensing of an IPR&D asset licensed from BexCaFe, LLC (BexCaFe) during 2022. See Note 6: Acquisitions, Divestitures and Other Arrangements for further discussion.

Interest Expense, Net of Capitalized Interest

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[[/GREPCENT_TABLE]]

Interest expense increased $5 million to $241 million in 2022, primarily due to $20 million in debt extinguishment losses recorded upon the retirement of a portion of the aggregate principal on our 4.272% Senior Notes due August 28, 2023 and our Term Loan B during the year and higher interest on variable-rate debt due to rate increases, partially offset by a lower average debt balance and the favorable impact of refinancing at lower interest rates.

Other (Income) Expense, Net

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[["","","Year Ended December 31,","","% Change"],["(Dollars in millions)","","2022","","2021","","2020","","22/21","","21/20"],["Other (income) expense, net","","$","32","","","$","5","","","$","(178)","","","NM","","NM"]]
[[/GREPCENT_TABLE]]

Other expense increased $27 million in 2022 as compared to 2021, primarily due to a $14 million increase in foreign exchange losses and a $14 million decrease in up-front payments received and milestones earned from business development arrangements.

Other expense recorded during 2022 primarily consisted of foreign exchange losses and mark-to-market adjustments on equity investments, partially offset by up-front payments received in relation to license and asset assignment agreements, the gain recognized on the disposal of our microbiome R&D platform, and certain components of net periodic benefit cost. See Note 19: Retirement Benefits to the consolidated financial statements for further discussion related to net periodic benefit cost (income) recorded during the period. Other expense recorded during 2021 primarily consisted of mark-to-market adjustments on equity investments and foreign exchange losses, partially offset by gains on divestitures, certain components of net periodic benefit income, an up-front payment received in relation to an asset assignment agreement, a milestone earned in relation to an existing asset sale agreement, and up-front payments received, milestones earned, and equity issued to us in relation to a license agreement.

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Income Tax Expense (Benefit)

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,","","% Change"],["(Dollars in millions)","","2022","","2021","","2020","","22/21","","21/20"],["Income tax expense (benefit)","","6","","(88)","","(103)","","107","%","","15","%"],["Effective tax rate","","(8)","%","","15","%","","15","%"]]
[[/GREPCENT_TABLE]]

Our historical income tax expense may not be indicative of our future expected tax rate. See “Comparability of Historical Results” for further discussion.

Income tax expense was $6 million in 2022 compared to an income tax benefit of $88 million in 2021. The change was primarily due to an increase in taxes on international operations driven by increased taxable income as well as an increase in state taxes in separate filing states offset by other decreases, including a $16 million Brazil income tax refund claim resulting from a Supreme Court decision rendered in 2022 that determined certain Brazil state valued-added tax (VAT) incentives were not subject to federal tax, a $17 million tax benefit due to the termination of interest rate swaps and a $12 million net reduction in taxes associated with the divestiture of the Speke manufacturing site. See Note 16: Income Taxes to our consolidated financial statements for further discussion.

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our credit facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. We intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. See Note 16: Income Taxes to the consolidated financial statements for further discussion. As our business evolves, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.

We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations which include principal and interest payments as well as interest rate swaps, operating lease payments, purchase obligations, and costs associated with the integration of Bayer Animal Health. In addition, we have the ability to access capital markets to obtain debt refinancing for longer-term funding, if required, to service our long-term debt obligations. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants.

Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful."

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Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented:

[[GREPCENT_TABLE]]
[["(Dollars in millions)","Year Ended December 31,","","$ Change"],["Net cash provided by (used for):","2022","","2021","","2020","","22/21","","21/20"],["Operating activities","$","452","","","$","483","","","$","(41)","","","$","(31)","","","$","524"],["Investing activities","(179)","","","(530)","","","(4,779)","","","351","","","4,249"],["Financing activities","(549)","","","210","","","4,954","","","(759)","","","(4,744)"],["Effect of exchange rate changes on cash and cash equivalents","(17)","","","(31)","","","27","","","14","","","(58)"],["Net increase (decrease) in cash, cash equivalents and restricted cash","$","(293)","","","$","132","","","$","161","","","$","(425)","","","$","(29)"]]
[[/GREPCENT_TABLE]]

Operating Activities

Our cash flow from operating activities decreased $31 million to $452 million for the year ended December 31, 2022 from $483 million for the year ended December 31, 2021. The decrease is primarily the result of a decrease in cash due to changes in operating assets and liabilities, particularly accounts receivable, inventories, and other assets, as compared to the prior year. This decrease was partially offset by a decrease in net loss after adjusting for non-cash items, as well as proceeds of $207 million from interest rate swap settlements in the current year. Due to the system integration scheduled to be completed in April 2023, we have and may need to further increase inventories on hand and extend payment terms for some customers during the first and second quarters of 2023 to ensure that our product is available for a period of time during which there may be no shipments. In the past, we have extended our payment terms for distributors on occasion. Although we presently have no plans to do so in the future, except for those related to the system integration described above, it is also possible that we will need to extend payment terms in certain situations as a result of the COVID-19 global health pandemic, competitive pressures, macroeconomic factors and the need for certain inventory levels in our distribution channels to avoid supply disruptions. If so, such extensions of customer payment terms could result in additional uses of our cash flow.

Investing Activities

Our cash flow used for investing activities decreased $351 million to $179 million for the year ended December 31, 2022 compared to $530 million for the year ended December 31, 2021. The decrease was primarily driven by cash paid for the acquisition of KindredBio during the year ended December 31, 2021, as well as a year over year decrease in cash paid for purchases of intangible assets. These decreases were partially offset by a year over year increase in cash used for purchases of property and equipment.

Financing Activities

Our cash used in financing activities was $549 million for the year ended December 31, 2022 compared to cash provided by financing activities of $210 million for the year ended December 31, 2021. Cash used for financing activities during 2022 primarily reflected the tender offer completed during the year as well as net repayments on our revolving credit facility and the repayment of indebtedness outstanding under our term loan B credit facility, partially offset by proceeds from our newly issued incremental term facilities. Cash provided by financing activities during 2021 primarily reflected proceeds from our borrowings under our debt financing arrangement with Farm Credit Mid-America, PCA, net proceeds from our revolving credit facility, and $64 million of funding received from the developer in connection with the construction of our new corporate headquarters in Indianapolis, Indiana, partially offset by the repayment of indebtedness outstanding under our Senior Notes.

Capital Expenditures and Software Purchases

Capital expenditures were $137 million during 2022, an increase of $11 million compared to 2021. Purchases of software were $34 million during 2022, an increase of $1 million compared to 2021. We expect 2023 capital expenditures and software purchases to be approximately $165 million to $190 million.

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Description of Indebtedness

For a complete description of our debt and available credit facilities as of December 31, 2022, see Note 10: Debt to the consolidated financial statements.

Contractual Obligations

Our contractual obligations and commitments as of December 31, 2022 are primarily comprised of long-term debt obligations, operating leases, and purchase obligations. Our long-term debt obligations are comprised of our expected principal and interest obligations. Purchase obligations consist of open purchase orders as of December 31, 2022 and contractual payment obligations with significant vendors which are noncancelable and are not contingent. These obligations are primarily short-term in nature. See Note 14: Leases to the consolidated financial statements for further discussion regarding the contractual obligations related to our new corporate headquarters in Indianapolis, Indiana.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Certain of our accounting policies are considered critical because these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often requiring the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our financial position and results of operations. We apply estimation methodologies consistently from year to year. The following is a summary of accounting policies that we consider critical to the consolidated financial statements.

Revenue Recognition

Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period that the revenue is recognized and that primarily represent revenue incentives (rebates and discounts) and sales returns. For example:

•for revenue incentives, we use our historical experience with similar incentives programs and current sales data and estimates of inventory levels at our channel distributors to evaluate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary; and

•for sales returns, we consider items such as: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; and estimates of the amount of time between shipment and return to estimate the impact of sales returns.

If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected.

Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions.

See Note 4: Summary of Significant Accounting Policies and Note 5: Revenue to the consolidated financial statements for further discussion regarding our revenue recognition policy and quantitative information regarding our rebate programs, respectively.

Acquisitions and Fair Value

We account for the assets acquired and liabilities assumed in an acquisition based on their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill.

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The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are determined using information available at the acquisition date based on expectations and assumptions that are deemed reasonable by management. These fair value estimates require significant judgment with respect to future revenues and EBIT margins, use of working capital, the selection of appropriate discount rates, product mix, income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. Depending on the facts and circumstances, we may deem it necessary to engage an independent valuation expert to assist in valuing significant assets and liabilities.

Impairment of Indefinite-Lived and Long-Lived Assets

We review the carrying value of long-lived assets (both intangible and tangible) for potential impairment on a periodic basis and whenever events or changes in circumstances indicate the carrying value of an asset (or asset group) may not be recoverable. We identify impairment by comparing the projected undiscounted cash flows to be generated by the asset (or asset group) to its carrying value. If an impairment is identified, a loss is recorded that is equal to the excess of the asset's carrying value over its fair value generally utilizing a discounted cash flow analysis, and the cost basis is adjusted.

Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually and when certain impairment indicators are present. We have historically performed our annual goodwill and indefinite-lived intangible asset impairment assessment as of the last day of the fourth fiscal quarter of each year. During the fourth quarter of 2022, we elected to change the date of our annual impairment assessment from December 31st to October 1st. The change was made to more closely align the impairment assessment date with our annual planning and budgeting process as well as our long-term planning and forecasting process. We have determined that this change in accounting principle is preferable and will not affect the consolidated financial statements. Pursuant to this change in accounting principle, in 2022 we performed an impairment assessment as of the first day of our fourth fiscal quarter. The change in impairment assessment date did not delay or avoid an impairment charge. This change is not applied retrospectively as it is impracticable to do so because retrospective application would require application of significant estimates and assumptions with the use of hindsight. Accordingly, the change has been applied prospectively.

When required, a comparison of fair value to the carrying amount of assets is performed to determine the amount of any impairment. In the third quarter of 2022, a significant change in our market capitalization relative to our book value, among other factors, triggered an impairment review. Based on our qualitative assessment, we concluded that it was more likely than not that the fair value of our single reporting unit was less than its carrying value, and therefore, we were required to perform a quantitative goodwill impairment test, which involved comparing the estimated fair value of our single reporting unit with its carrying value, including goodwill. As a result of the quantitative assessment, we concluded that no impairment existed with respect to our goodwill because the estimated fair value of our single reporting unit exceeded the carrying amount by more than 20%. Given the general worldwide economic conditions, we reevaluated our impairment testing from a qualitative perspective as December 31, 2022, which did not result in a change to our previous conclusion that no impairment exists.

Significant management judgment is required in estimating fair values in our impairment reviews and in the creation of forecasts of future operating results that are used in the discounted cash flow method of valuation. These include, but are not limited to, estimates and assumptions regarding (1) our future cash flows, revenue, and other profitability measures such as gross margin and EBITDA margin, (2) the long-term growth rate of our business, and (3) the determination of our weighted-average cost of capital, which is a factor in determining the discount rate. We make these judgments based on our historical experience, relevant market size, historical pricing of similar products, and expected industry trends. These assumptions are subject to change in future periods because of, among other things, additional information, financial information based on further historical experience, changes in competition, our investment decisions, volatility in foreign currency exchange rates, results of research and development, and changes in macroeconomic conditions, including rising interest rates and inflation. A change in these assumptions or the use of alternative estimates and assumptions could have a significant impact on the estimated fair value and may expose us to impairment losses.

During the years ended December 31, 2022, 2021 and 2020, we recorded asset impairments of $60 million, $66 million and $17 million, respectively. For more information related to our impairment charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

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Deferred Tax Asset Valuation Allowances

We maintain valuation allowances unless it is more likely than not that all of the deferred tax asset will be realized. Changes in valuation allowances are typically included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods, amount and availability of taxable temporary differences, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. Concluding that a valuation allowance is not required is difficult when there is significant negative evidence which is objective and verifiable, such as cumulative losses in recent years. We prepare a three-year cumulative pre-tax book income or loss analysis adjusted for certain permanent book to tax differences as a measure of our cumulative results in recent years. In the U.S. and certain foreign jurisdictions, our analysis indicates that we have cumulative three-year historical losses on this basis. This is considered significant negative evidence which is objective and verifiable and therefore, difficult to overcome. However, the three-year cumulative loss position is not solely determinative and accordingly, we consider all other available positive and negative evidence in our analysis. In making such judgments, significant weight is given to evidence that can be objectively verified.

As of December 31, 2022 and 2021, we had valuation allowances of $228 million and $182 million, respectively. In recent years we have incurred pre-tax losses in the U.S. primarily as a result of transaction, restructuring, integration and other costs. As a result, we have concluded that it is “more likely than not” that a portion of the U.S. deferred assets will not be utilized, and have recorded valuation allowances of $181 million and $162 million, respectively, against these deferred tax assets. Under current tax laws, the valuation allowance will not limit our ability to utilize U.S. deferred tax assets provided we can generate sufficient future taxable income in the U.S. We anticipate that we will continue to record a valuation allowance against the losses until such time as we are able to determine it is “more likely than not” that the deferred tax asset will be realized.

Recently Issued Accounting Pronouncements

For discussion of our new accounting standards, see "Item 8. Financial Statements and Supplementary Data — Note 4: Summary of Significant Accounting Policies - Implementation of New Financial Accounting ."