Elanco Animal Health Inc (ELAN) FY 2021 MD&A

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 ending December 31, 2020 and 2019, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the Securities and Exchange Commission on March 1, 2021.

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.

On August 27, 2021, we acquired KindredBio, a biopharmaceutical company that develops 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 5: Acquisitions and Divestitures 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 5: Acquisitions and Divestitures 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, 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 in order to meet pet owners where they want to purchase.

A summary of our 2021, 2020, and 2019 revenue and net income (loss) is as follows:

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Increases or decreases in inventory levels at our channel distributors 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, 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

The animal health industry, which focuses on 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

•increased pet spending as pets are viewed as members of the family by owners.

As demand for animal protein grows, farm animal health is becoming increasingly important. 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

COVID-19 Pandemic and Resulting Operating Environment

Our business has been impacted by the COVID-19 pandemic. We continue to monitor the global outbreak of COVID-19 and have worked with our customers, employees, suppliers and other stakeholders to mitigate the risks posed by its spread. The COVID-19 pandemic continues to impact the economy in the U.S. and globally, and has affected the operations of our company, vendors and suppliers, and supply of and demand for our products as follows:

Operations

As a result of the COVID-19 pandemic, governmental authorities implemented measures to try to contain the virus, such as travel bans and restrictions, limits on gatherings, quarantines, shelter-in-place orders, site closures and business shutdowns. These measures have affected the ability of our employees, vendors, and suppliers to perform their respective responsibilities and obligations relative to the conduct of our business. We have important manufacturing operations worldwide that have been impacted by the outbreak. Measures requiring business shutdowns generally exclude certain essential services, and those essential services commonly include critical infrastructure and the businesses that support that critical infrastructure. Because the animal health industry has been designated an essential business, our manufacturing and research facilities remain operational, while our employees in other company functions continue to primarily work remotely. These measures have impacted and may further impact our workforce and operations, as well as those of our customers, vendors and suppliers.

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In late 2020 and early 2021, vaccines effective in combating COVID-19 were authorized for use by health agencies in certain countries and regions in which we operate (including the U.S., U.K., European Union, Canada and Mexico) and began to be administered. While the outbreak recently appeared to be trending downward, particularly as vaccination rates increased, new variants of COVID-19 continue to emerge, including the Delta variant and Omicron variant, spreading throughout the U.S. and globally, causing some countries and regions to reinstate travel bans and restrictions. In addition, the availability of COVID-19 vaccines, their continued effectiveness and the need for and availability of boosters are difficult to predict, and vaccination levels vary across jurisdictions. The pace and shape of the COVID-19 recovery as well as the impact and extent of COVID-19 variants or potential resurgences are not presently known. As a result, it is possible the COVID-19 pandemic, particularly in light of variant strains of the virus, could further impact our operations and the operations of our customers, suppliers and vendors as a result of quarantines, facility closures, illnesses, and travel and logistics restrictions.

Supply

The COVID-19 pandemic and related economic effects have disrupted the global supply chain across all modes of transportation, which in turn has resulted in less reliable transportation schedules and increased freight costs. This disruption, combined with increased demand for key raw materials (including those used in COVID-19 vaccine manufacturing), has also impacted our suppliers, resulting in shortages of raw materials or 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 and targeted increases of certain safety stocks. 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 increases in shipping costs, negatively impacting our profitability.

Demand

The COVID-19 pandemic has adversely impacted global economic conditions. In particular, the COVID-19 pandemic created significant uncertainty for our channel distribution partners with respect to end customer demand and working capital. Our third party distributors may face difficulties maintaining operations and normal liquidity in light of government-mandated restrictions. Due to liquidity and working capital pressure caused by the COVID-19 pandemic, our distributors continue to manage inventory more tightly. In response to this, along with a shift in tactics for demand generation with our distributors, we reduced channel inventory levels during the first half of 2020 as we tightened our approach across all facets of our distributor relationships. We estimate that this decreased our revenue by approximately $160 million in the first half of 2020. These actions have allowed us to improve working capital management, increase gross margin, implement new compensation structures with our distributors and enable greater control of overall stock levels. For our pet health business, demand in our direct to retailer and e-commerce channels could be negatively impacted by economic conditions as they fluctuate.

In our farm animal business, demand was negatively impacted by processing plant closures in 2020, resulting in a backlog of animals ready for processing, and weakened food service demand, which collectively put pressure on producer economics. Processing plants have adjusted operations and have cleared most of the backlog, and demand for certain protein categories continues to recover. While the impact was most significant for the U.S. livestock industry, particularly in the second and third quarters of 2020, the pressure has occurred globally and across species. As the pandemic continued throughout 2021, our business was affected by lower levels of demand in certain markets due to unfavorable macroeconomic conditions and reduced food service consumption as well as an overall reduction in the bird and animal populations due to herd reduction and disease. As a result, the industry has seen lowered prices and producer profitability across species, most notably in international poultry and aqua. While we anticipate that recovery of end consumer demand will continue to occur, particularly in the food service business, this recovery may be negatively impacted by ongoing labor shortages in the swine, poultry, dairy and beef industries or the effect of inflation on customer profitability. We also expect this recovery to be volatile and uncertain. In addition, demand may be impacted by potential future mitigation measures such as shutdowns if prolonged resurgences in COVID-19 and its variants occur globally.

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We continue to monitor the impacts on our customers' liquidity and therefore our ability to collect on our accounts receivable. While our allowance on these receivables factors in expected credit losses, disruption and declines in the global economy could result in difficulties in our ability to collect, which we have not experienced on a material basis at this time. If significant issues with collections occur, material increases in our allowance for doubtful accounts may be required.

Our Acquisition of Bayer Animal Health and KindredBio

We have incurred and expect to continue to incur 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 2021 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

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 may develop through joint ventures and products that we are able to obtain through license or acquisition, 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 new product development, including generic alternatives to our products, quality, price, service and promotion. 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.

Prior to the acquisition of Bayer Animal Health, our acquisitions within the last six years added in the aggregate $1.4 billion in revenue, 4,600 full-time employees, 12 manufacturing and eight R&D sites. The acquisition 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 2021, 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 selling, general and administrative (SG&A) functions. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing three manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities through alternate sources of supply. Additional cost savings resulted from reducing the number of R&D sites from 16 to eight, SG&A savings from sales force consolidation, and reducing discretionary and other general and administrative (G&A) operating expense.

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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, 2021 and 2020, approximately 51% and 49%, respectively, 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 increased revenue by 1% during the year ended December 31, 2021. Currency movements decreased revenue by 1% and 2% during the years ended December 31, 2020 and 2019, 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.

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.

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.

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, and the sale of manufacturing sites; transaction 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, as we stand our organization up as an independent company.

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.

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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, included but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations."

Other Recent Acquisitions

Our financial results have been impacted by other recent acquisitions and integrations. For the periods presented, these include primarily the acquisitions and integrations of Aratana Therapeutics, Inc., which closed on July 18, 2019, and Prevtec Microbia Inc., which closed on July 31, 2019. For more information, see Note 5: Acquisitions and Divestitures to the consolidated financial statements.

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 2: Basis of Presentation to the consolidated financial statements.

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:

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:

Note: Numbers may not add due to rounding

*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.

Revenue

Pet Health revenue increased by $993 million or 73%, partially driven by Bayer Animal Health product revenue of $1,194 million as compared to $339 million in the prior year. Legacy Elanco revenue increased as a result of a favorable comparison to the prior year, during which we reduced channel inventory levels with our distributors in the first half of 2020 and experienced reduced demand for veterinary products, primarily in U.S. vaccines and international markets, due to the COVID-19 pandemic. Growth in the legacy Elanco business primarily related to increases in volume and price and, to a lesser extent, the positive impact of foreign exchange rates. U.S. parasiticides and therapeutics led price growth, and higher volumes were attributable to newer generation parasiticides, pain products, and new products launched in 2021. These factors were partially offset by declines in older generation parasiticides and the impact of divestitures.

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Farm Animal revenue increased by $497 million or 27%, mainly driven by Bayer Animal Health product revenue of $643 million as compared to $226 million in the prior year. Legacy Elanco revenue increased as a result of a favorable comparison to the prior year, which included lower levels of demand due to the COVID-19 pandemic's impact on global protein markets, as well as actions taken across brands to reduce channel inventory levels in the first half of 2020 due to the pandemic. Growth in the legacy Elanco business primarily related to increases in volume and a positive impact from foreign exchange rates. Revenue increases from volume growth in global cattle and U.S. swine, improvement in international poultry and aqua, and new products launched in 2021 were partially offset by generic competition, lower levels of demand in China's swine market due to pressured producer profitability, the impact from exiting certain operations in 2021, and an unfavorable comparison for U.S. cattle vaccines and implants, which benefited from a short-term competitor stock-out in the fourth quarter of 2020.

Contract Manufacturing revenue increased by $2 million to $82 million and represented 2% of total revenue. Contract Manufacturing revenue for the period includes $66 million resulting from the acquisition of Bayer Animal Health.

Cost of Sales

Cost of sales increased $467 million in 2021 as compared to 2020 primarily due to increased sales, partially offset by lower amortization of the inventory fair value adjustment associated with the Bayer Animal Health acquisition. Cost of sales as a percent of revenues decreased to 45% from 51%. This decrease was due to the inclusion of Bayer Animal Health products, which have higher margins, as well as continued improvements in manufacturing productivity, increases in price, and lower amortization of the inventory fair value adjustment.

Excluding the amortization of the inventory fair value adjustment associated with the Bayer Animal Health acquisition, cost of sales as a percent of revenue would have been 43% and 48% in 2021 and 2020, respectively.

Research and Development

R&D expenses increased $42 million to $369 million in 2021 as compared to 2020, primarily due to the inclusion of the Bayer Animal Health and KindredBio businesses. As a percent of revenue, research and development was 8% compared to 10% in the prior year. The decrease was primarily due to the rationalization of R&D projects, personnel and site operations in the current year following the acquisition of Bayer Animal Health as well as a higher revenue base.

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Marketing, Selling and Administrative

Marketing, selling and administrative expenses increased $408 million in 2021 compared to 2020, primarily as a result of the acquisition of Bayer Animal Health, increased promotional spend for direct-to-consumer and digital advertising, increased information technology spending, increased legal and administrative costs, and increased legacy Elanco compensation and benefits due to the addition of employees to perform activities that were previously covered by the TSAs with Lilly that were exited during the first half of 2021. These increases were partially offset by disciplined cost management across the business and realization of synergies.

Amortization of Intangible Assets

Amortization of intangible assets increased $196 million to $556 million in 2021 as compared to 2020, primarily due to the inclusion of a full year of amortization of intangible assets recorded from the acquisition of Bayer Animal Health.

Asset Impairment, Restructuring and Other Special Charges

For additional information regarding our asset impairment, restructuring and other special charges, see Note 6: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Asset impairment, restructuring and other special charges increased $5 million to $628 million in 2021 as compared to 2020, primarily due to a $273 million charge to write down assets at our Shawnee and Speke sites that were classified as held for sale to an amount equal to estimated fair value less costs to sell, a $26 million charge to establish a liability for future royalty and milestone payments relating to our canine parvovirus license agreement with KindredBio, and $66 million of impairment charges for intangible assets that were subject to product rationalization in the current year. The impact of these items was partially offset by a year over year decrease in overall acquisition related charges, which include transaction costs related to acquisitions, costs associated with the implementation of new systems, programs, and processes due to our separation from Lilly, and costs associated with the implementation of new systems, programs, and processes in connection with the integration of Bayer Animal Health. The increase as compared to prior year was also partially offset by a decrease in severance charges as compared to 2020, $29 million of pension curtailment gains and a $16 million reversal of severance accruals during the period due primarily to favorable negotiations.

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Interest Expense, Net of Capitalized Interest

Interest expense increased $86 million to $236 million in 2021, primarily due to interest associated with the Term Loan B entered into August 1, 2020 and used to finance the Bayer Animal Health acquisition and additional debt used to finance the KindredBio acquisition.

Other (Income) Expense, Net

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. Other income recorded during 2020 was primarily composed of gains recorded on the divestitures of certain products and a $46 million gain on the sale of land and buildings in New South Wales, Australia.

Income Tax Expense (Benefit)

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 benefit decreased $17 million to $95 million in 2021, primarily due to a pre-tax loss partially offset by a non-cash charge of $62 million relating to the increase of the valuation allowance on U.S deferred tax assets. See Note 15: Income Taxes to our consolidated financial statements.

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 currently intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. See Note 15: Income Taxes to the consolidated financial statements for further discussion. As our structure evolves as a standalone company, 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.

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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 integrations of Bayer Animal Health and KindredBio. 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."

Cash Flows

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

Operating Activities

Our cash flow from operating activities increased by $524 million from cash used for operating activities of $41 million for the year ended December 31, 2020 to cash provided by operating activities of $483 million for the year ended December 31, 2021. The increase is primarily attributable to a decrease in net loss year over year as well as a favorable impact on cash from the exclusion of non-cash items included in net loss during 2021 as compared to 2020. The impact of these items was partially offset by a decrease in cash due to changes in operating assets and liabilities, particularly accounts payable and other liabilities, as compared to the prior year. Cash provided by operating activities during 2021 as compared to 2020 reflects the impact of the acquisition of Bayer Animal Health on our results for a full year, a favorable comparison to the prior year due to the channel inventory reduction in the first half of 2020, and the overall recovery observed in the current year after the COVID-19 pandemic impacted the global economy for much of 2020. 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, it is possible that we will need to extend payment terms in certain situations as a result of the COVID-19 pandemic, competitive pressures and the need for certain inventory levels at our channel distributors to avoid supply disruptions. If so, such extensions of customer payment terms could result in additional uses of our cash flow.

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Investing Activities

Our cash flow used for investing activities decreased $4,249 million to $530 million for the year ended December 31, 2021 compared to $4,779 million for the year ended December 31, 2020. The decrease was primarily driven by lower cash paid for acquisitions as well as a decrease in purchases of software, partially offset by a decrease in proceeds from product divestitures. During 2021, cash paid for acquisitions was comprised of $444 million of cash consideration paid to acquire KindredBio, partially offset by cash acquired from KindredBio and the impact of the finalization of the working capital adjustment related to the acquisition of Bayer Animal Health. Cash used for investing activities during 2020 was composed of $5,170 million of cash consideration paid to acquire Bayer Animal Health, partially offset by cash acquired from Bayer Animal Health and proceeds from product divestitures and the settlement of net investment hedges.

Financing Activities

Our cash provided by financing activities decreased $4,744 million to $210 million for the year ended December 31, 2021 compared to $4,954 million for the year ended December 31, 2020. Cash provided by financing activities during 2021 primarily reflected proceeds from our borrowings under our new debt financing arrangement with Farm Credit, 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 and revolving credit facility. Cash provided by financing activities during 2020 reflected proceeds from our borrowings under the Term Loan B and revolving credit facility and issuances of common stock and TEUs to finance the acquisition of Bayer Animal Health during the period, partially offset by the repayment of indebtedness outstanding under our credit facilities.

Capital Expenditures and Software Purchases

Capital expenditures were $126 million during 2021, a decrease of $9 million compared to 2020. Purchases of software were $33 million during 2021, a decrease of $143 million compared to 2020. We expect 2022 capital expenditures and software purchases to be approximately $155 million to $185 million.

Description of Indebtedness

For a complete description of our debt and available credit facilities as of December 31, 2021, see Note 9: Debt to the consolidated financial statements.

Contractual Obligations

Our contractual obligations and commitments as of December 31, 2021 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 and our interest rate swaps. Purchase obligations consist of open purchase orders as of December 31, 2021 and contractual payment obligations with significant vendors which are noncancelable and are not contingent. These obligations are primarily short-term in nature. See Note 13: 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.

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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 estimate 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 3: Summary of Significant Accounting Policies and Note 4: 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.

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 equal to the excess of the asset's net book value over its fair value 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. When required, a comparison of fair value to the carrying amount of assets is performed to determine the amount of any impairment.

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The estimated cash flows and fair values used in our impairment reviews require significant judgment with respect to future volume; use of working capital; foreign currency exchange rates; 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. 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, and results of research and development. A change in these assumptions or the use of alternative estimates and assumptions could have a significant impact on the estimated fair values of the assets and may result in an impairment of the existing assets in a future period.

During the years ended December 31, 2021, 2020 and 2019, we recorded asset impairments of $66 million, $17 million and $16 million, respectively. For more information related to our impairment charges, see Note 6: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

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 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 pre-tax book 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 pre-tax book 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, 2021 and 2020, we had valuation allowances of $162 million and $94 million, respectively. In recent years we have incurred pre-tax book losses in the U.S. primarily as a result of transaction, restructuring, integration and other costs as well as the negative impacts of the COVID-19 pandemic. As a result, we have concluded that it is “more likely than not” that we will not be able to utilize a portion of the U.S. deferred tax assets and have recorded valuation allowances of $162 million and $75 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 Note 3: Summary of Significant Accounting Policies - Implementation of New Financial Accounting Pronouncements to the consolidated financial statements.

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