Markets move fast, and the news flow out of Mallinckrodt (MNK) has been interesting over the last week, to say the least. From last Thursday’s “unfortunate” Latham & Watkins restructuring rumor, to Friday’s opioid settlement news in the state of Ohio, to this week’s BioVectra and Purdue Pharma news, it’s been dramatic. But perhaps the most interesting news for investors is Tuesday’s statement from the company stating that the recent news has opened a “clear pathway” to paying off the 2020 bonds in full, combined with the company’s debt reduction trajectory and free cash flow potential backing up the statement.
This is an “opportunistic” investment, and things change quickly under the opioid cloud, but the 6.7% current yield on Mallinckrodt’s deeply discounted 2020 bonds (trading at 72 cents on the dollar) is attractive and worth considering for a spot in your prudently diversified high return portfolio.
Mallinckrodt is a specialty pharmaceuticals company that develops, manufactures, markets and distributes both branded and generic specialty pharmaceutical products and medical imaging agents. And as you can see in the price chart below, the company’s 2020 bonds have been under a world of pressure.
(image source: Finra Morningstar, see also cusip L6233LAB2)
Why the Bond Price Has Dropped
The price has dropped for a variety of reasons, including the opioid crisis, Acthar Gel challenges, industry headwinds, a delayed spinoff, and now the latest batch of news over the last five trading days. Let’s take a closer look at some of the specifics.
1. The Opioid Crisis: Lawsuits and Bad Press
Investors are scared and Mallinckrodt has been receiving bad press related to the opioid crisis. Nearly 400,000 Americans have died from opioid overdoses from 1999 to 2017, according to the Centers for Disease Control and Prevention, with the rate of deaths picking up over time. Currently ~2,000 lawsuits have been brought by municipalities and other plaintiffs accusing companies in the pharmaceutical supply chain, including Mallinckrodt, of fueling the opioid epidemic. A Mallinckrodt spokesman said the company would vigorously defend itself against the claims and that “at this point, there is no settlement that is probable and estimable.” He also said Mallinckrodt expects any such future settlement to be manageable (more on the opioid lawsuits later).
2. Acthar Gel: Lawsuits and Stagnating Growth
Acthar Gel accounted for 35% of Mallinckrodt sales in 2018, and the product faces uncertainties related to lawsuits and stagnating growth. If you don’t know, Acthar Gel is injected beneath the skin or into the muscle, and is used for treatment of a variety of inflammations (such as flares in people with lupus, infantile spasms, and multiple sclerosis, to name a few).
Mallinckrodt has been charged with claims the product was improperly marketed and doctors were bribed to prescribe it. Mallinckrodt has already settled multiple lawsuits, but recently filed new lawsuits have created a new wave of uncertainty.
Acthar Gel has not shown significant sales growth since 2014 (when the product was acquired by Mallinckrodt as part of the Questor acquisition). For perspective, annual sales for the product have been fairly consistent since the acquisition at ~$1.0 billion. However, since the acquisition, Mallinckrodt has invested more than $500 million into Acthar Gel, with a focus on generating data to demonstrate the effectiveness of the drug in other disease models.
3. Industry Marred by Headwinds:
The pharmaceutical industry is currently facing a range of issues including the opioid litigation, public resistance to drug-price increases, the possibility of universal health-care legislation, lawsuits alleging that pharmaceutical companies colluded to raise generic drug prices and the Trump administration’s proposed overhaul of drug rebates. These issues have resulted in the sector becoming the worst-performing sector in the S&P 500 this year. The nature of the issues has given rise to a cloud of negativity over the industry due to which the industry multiple has fallen.
4. Spin-Off Delayed:
During the company’s most recent earnings call, management announced they would be suspending their previously announced spin-off of the generics business based on current market conditions, primarily opioid litigation. The spin was expected to improve the liquidity situation with the specialty generics company raising debt of up to $300 million, with an anticipated $150 million in EBITDA. Net proceeds from the debt were to be distributed to the parent, which was to further help in reducing leverage. The delay of the spin adds uncertainty to the company’s refinancing of debt and liquidity.
5. News Flow Over the last 5 Days:
Perhaps most interesting has been the Mallinckrodt news flow over the last 5 trading sessions. It started last week with a rumor that the company had hired law firm Latham & Watkins to consider restructuring as major opioid trials near. However, Mallinckrodt’s CEO downplayed the report calling it:
“unfortunate” since the company routinely hires advisors for a range of issues, although he added that it continues to look at all alternatives to move away from the opioid/generics business since it comprises only 10% of what the company does.”
Next, On Friday, Mallinckrodt agreed to settle Track 1 opioid cases in Ohio by paying $24 million in cash plus $6 million of donated generic products, including meds to treat opioid addiction.
“Mallinckrodt is pleased we were able to reach a settlement in principle with the counties that made sense for all parties,” said Mark Casey, General Counsel of Mallinckrodt. “Resolving the Track 1 Cases gives us the necessary time to continue to work towards a global resolution of the opioid lawsuits.”
And then on Tuesday, Mallinckrodt announced it had agreed to Sell BioVectra for up to $250 Million, thereby freeing up more cash, and further improving the company’s liquidity position.
Further, news broke that Purdue Pharma (maker of branded opioid drug OxyContin) was nearing a partial opioid settlement and bankruptcy filing (it’s important to note Purdue sold a branded opioid drug, versus generics for Mallinckrodt, more on this later).
However, one of the most exciting pieces of news came from management during Tuesdays Morgan Stanley Healthcare conference when the company announced it now has a “clear pathway” to paying off the 2020 bonds. According to Chief Financial Officer, Bryan Reasons:
“Our next maturity is April 2020 and that’s a $700 million tranche. And we do believe that even if the worst case… we have a clear pathway to take care of that maturity through cash on the balance sheet, liquidity between now and then from cash flows, and plenty of secured capacity.”
That worst case scenario is with regards to a pending decision from a judge related to Acthar Gel. How it gets resolved will determine how Mallinckrodt proceeds with its debt maturities, but even in the worst case scenario the company expects to pay off the 2020 bonds.
What Else Do We Like About The Bonds:
Despite all the negativity and risks, and in additional to the good news over the last week, there are more things we like about these bonds. For example, Mallinckrodt has strong free cash flow and improving financials, they’ve been paying down debt, they have a healthy pipeline ahead (both Acthar Gel and otherwise) and the company is arguably less culpable in opioid lawsuits due to its generic (non-branded) opioids.
1. Strong Free Cash Flow and Improving Financials:
Per the table below, Mallinckrodt generated free cash flow in excess of $500 million in FY 2017 and FY 2018 at a margin of ~16.7%. The company has been able to achieve this despite operating in an environment where the government is pushing hard to control rising drug costs and facing pressure from payers regarding reimbursement rates. Management expects free cash flow to be even higher in 2019 and is on track to achieve this, having performed better than expected in Q1 and Q2 2019.
(source: Factset, Analyst Estimates)
For perspective, the company’s decline in profitability between 2016 and 2018 was primarily attributable to the Specialty Generics segment. The operating margin in this segment declined from 40.7% in FY 2016 to 30.6% in FY 2017, declining further to a lowly 11.5% in FY 2018. Performance for the segment improved significantly in the first half of 2019, with operating margin increasing to 23.8% in Q1. Management increased the full year revenue guidance for the segment based on volume recapture and positive trends forecasted for the business.
2. Healthy pipeline with two product launches expected in 2020:
Mallinckrodt’s hospital portfolio is the company’s largest and fastest growing platform in terms of total sales. Management expects this to be the company’s long-term growth engine with a number of product launches planned over the next few years. Terlipressin and StrataGraft are the two key products expected to drive near term growth with estimated combined global peak sales in excess of $450 million. Phase 3 data releases are imminent, and the company expects to launch them in 2020. This is important because their projected revenue is expected to exceed the estimated decline in sales from the loss of exclusivity of Ofirmev in 2021 and the potential competition for Inomax.
Further, with regards to Acthar Gel, Mallinckrodt strategy is to modernize the brand. Meaning simply, according to Mark Trudeau (during the Morgan Stanley Healthcare Conference), that “the company is creating a data set that’s contemporary and modern and that addresses the appropriate patients for Acthar.” He notes that the company has “half a dozen other clinical trials that are currently running that will play out over the next 12 to 18 months. And by the end of 2020, we’ll have a very clear idea of what Acthar is and what Acthar isn’t.”
Overall, Mallinckrodt remains confident in the ability of these programs to drive long-term growth, so it will continue to fund them as necessary. We view the increased R&D favorably because increased spending on drug development indicates the company’s confidence in the quality of its pipeline.
3. Significant debt reduction since Q3 2018:
Mallinckrodt has been significantly reducing its net debt since Q3 of 2018, a positive sign for its ability to support existing interest payment and debt levels.
(source: FactSet, USD in millions)
We generally view bond repurchases using free cash flows favorably, especially when they decrease total leverage of the company. These actions by Mallinckrodt make sense since they will help ensure the company is appropriately capitalized. And with Mallinckrodt’s bonds trading at a significant discount, it allows the company to redeem higher cost debt and accelerate the process toward deleveraging goals.
The maturity of the 4.875% notes due April 2020 may be a cause of concern for many investors. However, the company has stated (just this week) that they have a clear pathway to paying them off, and we agree.
4. Generic Versus Branded Opioids:
Mallinckrodt’s position is that because they sold generic opioids (instead of branded opioids like Purdue Pharma’s OxyContin) they are less culpable in lawsuits. Specifically, Purdue Pharma was actively pushing, marketing and selling their branded drug, whereas Mallinckrodt was simply selling a generic product that was arguably already fully vetted. In this sense, Mallinckrodt may be less culpable in outstanding opioid lawsuits.
The challenges at Mallinckrodt are real, and we are avoiding the stock (even though most Wall Street analysts still rate the shares a hold or a buy, as shown in the following chart).
(image source: Factset)
However, we view the 2020 bonds as attractive, considering the news flow over the last week (particularly the company’s explicit statement that there is now a “clear pathway” to paying them off), especially considering they appear to have the cash flow to do it. And while the opioid litigation continues to whipsaw the entire industry (for example, our high return opportunity last week was the 8.8% yield on Teva Bonds) (TEVA), we believe this week’s opportunity (Mallinckrodt’s 2020 bonds) also offer an attractive risk-reward within the constructs of an opportunistic, prudently-diversified, high-return portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.