Reality Catches Up To Mallinckrodt 4 Years Later

| About: Mallinckrodt PLC (MNK)

Summary

The market prices Mallinckrodt equity at about $16 per share, at a Non-GAAP forward PE of about 2.

I think this pricing means the market has determined there is overwhelming risk in owning Mallinckrodt common stock.

I believe this risk comes from the company's irresponsible and overwhelming use of leverage, as well as from product concentration.

The Acthar fairy tale that Citron Research, David Einhorn, I and others first identified in 2014 could be running out of momentum.

I believe the government is wising up, the healthcare industry is wising up and finally, the market is wising up. Mallinckrodt equity could be a $0.

Mallinckrodt (MNK) is being considered on Seeking Alpha as a potential long idea again, because of the low valuation that stock appears to have when viewed strictly on a quantitative basis. Quants running valuation screens, without knowing the details of the business, could be attracted to what appears to be incredible value.

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MNK PE Ratio (Forward) data by YCharts

But just as it is important to be skeptical of a dividend stock who has seen its yield increase substantially because of its equity falling in price, it is important to understand why MNK looks so "cheap" at these prices.

It is true - if you run a screen that looks for traditional value, there's a good chance that MNK, with its forward PE of about 2, could very well show up on this screen. As a matter of fact, if you're running a screener looking for potential "value" plays and you're ignoring debt or YOY growth figures in revenue and/or EPS, there's a good chance that MNK would be on your desk.

However, going forward, it is my opinion that the stock has to be avoided: there are still far too many unknowns surrounding Mallinckrodt. As it stands, in March of 2018, my main concerns with the business, despite its "cheap" equity price would be as follows:

1. The company's leverage is at levels where everything must work perfectly for them in the future to manage their interest expense. The business must continue to generate cash consistently, otherwise the company could very easily be heading for a restructuring scenario.

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MNK Total Interest Expense (NYSE:TTM) data by YCharts

2. Acthar continues to be closely scrutinized, not only by insurance companies for the purposes of reimbursement, but also due to its efficacy versus much cheaper alternatives. In a game changing move for the Acthar landscape, MNK had to offload its ownership of a synthetic version of Acthar (closely related, not exactly the same), which has not been compared in studies with Acthar for many of Acthar's main indication uses. Though this has not posed a threat yet, the Acthar risk column has certainly shifted, and not in favor of the company.

3. The healthcare landscape has shifted. The environment for MNK in 2013/2014 was ripe - there was no serious outrage about drug pricing yet and it wasn't a major public issue like it is now.

Given that MNK has so much debt and numbers for Acthar have been largely inconsistent, the market is proceeding with caution when it comes to pricing Mallinckrodt's equity. I believe the market is right in being skeptical.

No matter how cheap the stock appears on the PE front right now, that is automatically meaningless under the light of how much debt the company has and how much risk there is related to Acthar. The company has too much leverage and nothing has changed for the better on the Acthar landscape since 2014. Government scrutiny of healthcare companies hasn’t subsided, in fact, it has gotten worse. The New York Times continued to point out that it's an issue in an article published in early March 2018:

The burden of high drug costs weighs most heavily on the sickest Americans.

Drug makers have raised prices on treatments for life-threatening or chronic conditions like multiple sclerosis, diabetes and cancer. In turn, insurers have shifted more of those costs onto consumers. Saddled with high deductibles and other out-of-pocket costs that expose them to a drug’s rising list price, many people are paying thousands of dollars a month merely to survive.

Yet to this day, Mallinckrodt has offered no positive serious clinical data that could possibly counteract a lot of the concerns about the efficacy of Acthar that have been in the public for all of these years. The company just doesn’t really seem to have any substantial business prospects or meaningful avenues for growth right now. To me, it looks like it could be dead in the water.

One could mark my longstanding bearish stance on Mallinckrodt as almost a total Pyrrhic victory. A Pyrrhic victory is "a victory that inflicts such a devastating toll on the victor that it is tantamount to defeat. Someone who wins a Pyrrhic victory has been victorious in some way, though the heavy toll negates a true sense of achievement or profit."

Though this one isn't quite Pyrrhic - actually, I feel good about the way this story played out. It's Pyrrhic in the sense that no real money was made by me. In fact, money was lost on Questcor (I was short when they were bought out) and then again on Mallinckrodt (I was short when the stock quadrupled). However, this is a case where it appears that common sense, ethics and the "good guys" arguing the "right" side may get their way. It also seems to be a case where the company may have been maimed and bludgeoned beyond recovery.

Long after I have had any substantial short position in Mallinckrodt (MNK), reality has finally appeared to reach the healthcare industry, the government and - most importantly - the market.

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MNK data by YCharts

I've had to ask myself a question about Mallinckrodt: is it worth it to watch a company finally have to pay the piper ethically, even if my monetary interest in the trade has long since dissolved? The answer in this case has been a resounding "yes". In fact, it's a scenario that I could see eventually playing out with Herbalife (HLF) down the road, as well, as I talked about on one of my recent podcasts.

At this point, I personally think Mallinckrodt is out of options. I've always regarded it as a poor investment due to its reliance on Acthar. Not many of my previous criticisms, if any, about the company, have been alleviated.

Now that QTR is back occasionally writing articles for Seeking Alpha, I wanted to take a "trip down memory lane" to provide somewhat of a post-mortem, as well as to give my thoughts on why I would not invest in Mallinckrodt here, either. Before making this sound too much like a victory lap, I want to remind readers that I am often wrong. I've been wrong on many, many instances and readers should consider that before reading further.

The last time I wrote about Mallinckrodt (MNK) for Seeking Alpha was all the way back in summer of 2014. The title of that article was "Mallinckrodt's CEO Could Be Leading His Shareholders To The Slaughter". I concluded by saying:

Considering MNK is levering up to make this transaction, I think this has the potential to be a slaughter for MNK shareholders. The last line of defense here is the shareholders, who vote on August 14th. While it's a lovely thought to think that the common folk could have a chance in voting this down, institutions and profit-minded thinking will push this deal forward, where MNK may become one of the better short candidates I've ever seen.

In return, here's some of the comments I was treated to at the end of this, and several other Mallinckrodt articles published around the same time:

In addition, I briefly follow up on my Mallinckrodt criticism when I wrote this piece for GeoInvesting in September of 2016, outraged that Mallinckrodt was not being investigated by the same government who was spending countless time and resources on both Mylan's (MYL) Epi-Pen and Martin Shkreli. I'm not saying either of these two were not worthy of government scrutiny, just that the government was - again - missing the lowest hanging fruit in the room, in my opinion.

I was happy to see that the government is taking healthcare related questionable claims seriously, as it was announced yesterday that the SEC had charged Theranos founder Elizabeth Holmes with "massive fraud". I had also recently criticized the government's lack of action on Holmes, when compared to Shkreli, in this podcast and in an article I contributed to Zerohedge. Needless to say, I was glad to see the government take action.

Back to Mallinckrodt - one of the main questions is how a stock like this has such a triumphant fall from grace. Many of the concerns that I expressed in my articles in 2014 came to fruition, with some of these persisting to this day and continuing to put downward pressure on the stock price.

For instance, let’s take a look at some of the concerns that I brought up back in 2014, and how they played out:

1. Reimbursement

2014: I took exception with this line from Mallinckrodt's conference call, stating that reimbursement could very easily become a tangible issue for Mallinckrodt in the future:

What we continue to see and we've seen this in the due diligence of the product is that the reimbursement status or the actual reimbursement of the product continues to remain strong, really regardless of what the changes to the reimbursement policies tend to be.

This came after UnitedHealth, in 2014, found the drug to be "not medically necessary" for some indications. Folks, this is usually a sign that the reimbursement wheels could eventually fall off:

UnitedHealth is a massive player in the medical coverage field, and their drug policy on Acthar is nothing short of a huge deal.

As you can see from copies of UnitedHealth's report retrieved on Friday, the policy that goes into effect for Acthar on 8/1/14 "updated unproven and not medically necessary criteria" about the drug.

But that wasn't enough proof for people. Nor was the fact that Aetna's National Medical Director slammed the drug at a conference in 2014 - nearly 4 years ago:

Questcor's "combination of aggressive marketing and aggressive price increases finally caused it to become a line item that a finance guy looked at and said: 'What the hell are we paying for this? Why? What is it?' And that's when we started looking at what's our policy around this stuff," Pazella said

That wasn't enough. He went on to say, when asked about reimbursement in 2014:

We see a gradual decline, and hopefully almost no use outside of infantile spasms within the next couple of years. This is one of those things that's taking a while.

2018: Private insurers continue to crack down on Acthar reimbursement and criticism continues to strengthen, Barclays downgrades the stock in February 2018 "citing reimbursement challenges for top seller H.P. Acthar Gel that could pressure sales growth". In late 2017, Oppenheimer downgraded the stock for the same read, citing "lack of growth visibility for arthritis drug Acthar as a key factor".

2. Leverage

2014: I stated in August of 2014 that leverage could come back to bite the company in the behind:

Really, Mr. Trudeau? You're levering up your company and betting the house that four major insurers are all going to make policy changes on paper that they're just simply not going to make in practice?

2018: In January of 2018, Moody's put the company's debt under review for a downgrade. The company's total debt now stands at almost $7 billion, which sees its debt/run rate EBITDA above 4x. In addition, analysts have identified additional potential debt liabilities that hadn't necessarily been made clear to the market. The debt appears to be the main culprit weighing down the equity price, which appears to not be priced based on the company's earnings potential, but rather its outstanding risks.

3. Efficacy

2014: Throughout my series of articles, I constantly raised the point that Acthar lacked current clinical trials, akin to the kind that the FDA requires for approval nowadays, on many of its indications. As the New York Times stated, when writing about Questcor, "Because Acthar was approved for these conditions decades ago, Questcor has not had to do large clinical trials to show that the drug works. It has paid for some small studies, mainly by individual doctors, who then publish a paper that the sales force can present to doctors."

2018: In 2015, Mallinckrodt did run one “eight-week, double-blind, randomized placebo-controlled trial that assessed the clinical efficacy of repository corticotropin injection (NYSE:RCI) in 38 patients with persistently active SLE involving skin and/or joints despite moderate dose corticosteroids” that failed to meet its primary endpoint. As Linette Lopez at Business Insider reported in 2017, "Mallinckrodt and Acthar's previous owner, Questcor, have yet to produce any studies showing that Acthar is superior to its cheaper alternatives. In the case of MS, that alternative is methylprednisolone, an intravenous treatment that cost $1,000 to $2,000 as opposed to Acthar's $40,000."

In 2017, the company offered up a half-assed insult to your intelligence PR to the efficacy question, putting out a press release trying to “clear the air” about Acthar. The company cited a bunch of official looking “articles” to back up Acthar's use in other indications from infantile spasms. Presumably the company wanted us to think these articles are something close to double blind placebo controlled clinical trials. The truth is that I don't think they are anything of the sort, but instead are subjective articles referencing an experience here and there, and references to studies that may not meet the same rigorous standards that the FDA now requires. I swiftly dealt with this nonsense in 2017 by writing my Pulitzer hopeful entitled, "Does Mallinckrodt Think We Are All Morons?".

4. Healthcare Headwinds

2014: When I first started writing about Questcor, I considered its business model as nothing more than finding a loophole in the healthcare system to exploit. This worked out well for tons of pharma companies, including specialty pharma companies up to 2015, when then Presidential candidate Hillary Clinton took notice and put a major dent in the sector with a Tweet that would start an environment of criticism for drug pricing that persists today.

2018: "The Wall Street Journal reports that all drug makers are facing the same headwinds as payers are pushing back on price hikes, easily passed through until recently."

On top of this, a lot of my thesis was also based on good, old fashioned common sense:

The short thesis on Questcor has stemmed from the old adage of "if it's too good to be true, it likely is". The company is currently being investigated by several regulators for the way in which it has been promoting the sale of its sole product. More recently, independent lab reports seem to have shown that the drug the company is shipping may not be what's on the label. In science, the technical term for that would be a "major no-no."

I have also been fairly critical of MNK on my Twitter feed over the last couple of years, even though I have taken a break from writing about the company. I had felt that the song and dance that the company had done over the last couple of years was all leading in the wrong direction.

There were rumors about the company putting itself up for sale, followed by management stating that it would, then would not, then would again consider acquisitions as part of its business strategy. There were asset divestitures and purchases several times over. However, nothing could draw attention away from the fact that this company’s goose was cooked, as I predicted, when it acquired Questcor to begin with:

Back in 2014, I urged MNK shareholders to consider trying to get vocal against the acquisition of Questcor. I figured that, at the time, Questcor was getting the better of this deal. It seemed fairly obvious to me because Questcor's projections for sales of Acthar were really optimistic looking, yet when they sold the company, they did so at what I thought was a fairly modest premium.

This was a sign to me that, rather than waiting for the best deal, Questcor was instead in somewhat of a rush to sell itself.

Questcor shareholders really had the best deal out of anybody involved with this whole fiasco. They somehow didn't let common sense get in the way of a stock that kept going up. Good job on turning that part of your brain off, I guess.

(Photo credit: Questcor, Amigobulls.com)

A perfect scenario would have been going long Questcor and then long Mallinckrodt just for the first couple of months of 2015 after the deal closed.

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MNK data by YCharts

From there, the price "adjustment" I had sought and predicted finally took place over the course of a couple years.

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MNK data by YCharts

But as you can see, when reality hits, it often hits swiftly and Mallinckrodt has now been abruptly brought back down to levels that are around 90% off of its highs. This was a price adjustment that I had been predicting for years.

What then becomes of the company's possible paths forward from this point on? It’s either going to be able to crawl out of its debt hole eventually or is going to be headed for a restructuring of some kind. When you look at similar case studies, companies like Valeant (VRX) have only been able to survive their enormous leverage because they have a wide selection of products that they can fall back on. Even though Valeant underwent its collapse in share price, it may still have some wiggle room to slither its way out from underneath it’s debt, over a very long course of time, because it is diversified with its products.

But even companies that were diversified with their product lines (but ran into regulatory issues), like Concordia version 1.0 (CXRX), eventually fell victim to their substantial debt load and had to restructure.

For me, it has certainly been a learning experience and a lesson in timing and psychology as they relate to short selling. You can have all of the facts right, but if your timing isn’t correct, you’re not going to be successful. Herbalife, I predict, will be another lesson in the same along the same lines. I predict that eventually the company is going to have to blowout its share structure and sacrifice some of its cash generative business in order to survive, assuming it doesn’t fall victim to additional regulatory hurdles. This is going to come over time and, as I pointed out in this article and in this podcast, while I believe my facts to be right, my timing was obviously off in shorting the stock.

Mallinckrodt has provided a similar lesson, but now it’s easy for me to see that the market's pricing of the equity has correctly determined it to be an extremely high-risk scenario. Of course, with high-risk could come large rewards. If the company is able to keep going and still rely on Acthar to provide it with cash, or if the company is able to make acquisitions that provide some kind of story that convinces the market there could be future growth, the equity could very well have substantial upside, as has been stated by some SA contributors. However the debt burden is too much and the regulatory environment for healthcare is too much of a headwind at this point for me to seriously consider giving the long case any type of real credibility at this point.

As a contrarian investor, especially one who has been a long time vocal critic of the company, nothing would excite me more than for the company to reach some type of point where the equity is so cheap that it absolutely can’t be ignored as something to toss around as a long idea. Going long on a name that you were previously short, with good reason, can often times be a lucrative investment strategy. Sometimes being an aggressive and well informed short can be the best way to learn all of the intricacies of a company, in order to help determine when turning around on your strategy is a good move. If you wanted example of this, look no further than Marc Cohodes turning around on Overstock (OSTK), which I believe he disclosed somewhere close to $23 per share and has seen the stock go as high as over $80 per share, before recently falling back down closer to $46 per share after yesterday's dumpster fire of an earnings release. If the opportunity to make money is there and the fundamentals of the underlying thesis have changed for the better while the stock has gotten cheaper and sentiment has gotten exhaustively bad, that can sometimes be very compelling reason to change your mind. I have examined Mallinckrodt from this point of view, but a lot of my original concerns still remain. Thus, I remain a skeptic and believe that Mallinckrodt has a tough road ahead of it.

To conclude, it is fun to go back and look at parts of my thesis from several years ago that have come to fruition. As I said today on Twitter, I’m often wrong, so it is a nice feeling to see a thesis that I worked somewhat diligently on to finally play out over time. It is even more for filling to conceptualize the fact that this whole "game" that MNK thinks constitutes a business plan could eventually come to a halt.

But on top of this, it is even more meaningful and more appropriate to look at how these risks stack up currently. After all, that is what will determine whether or not the company would make for a good investment today. In the case of this company, many of these risks, if not all of them, still remain outstanding and it’s really difficult for me to come up with a scenario where I could confidently take any type of long position. Rather, it is my opinion that the company is more likely to be heading to an eventual scenario where a restructuring may be a viable option, especially in a rising interest rate environment.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.