Mallinckrodt dashes hopes of a return to valuation fundamentals

Analysis

Hopes that the recent pullback in biotech sentiment would prompt more rational thinking as regards underlying company valuations were cruelly dashed yesterday when Mallinckrodt shelled out $5.6bn to buy Questcor Pharmaceuticals.

Not only does Questcor’s business rely on a regulatory loophole, but the company also faces legal and competitive threats. None of this bothers Mallinckrodt’s management, which seems determined to bulk up through M&A at any cost, presumably in the hope that the group will eventually be sold itself.

The move, $1.8bn of which will be paid for in cash, follows hot on the heels of Mallinckrodt’s takeout of another struggling business, Cadence Pharmaceuticals (Mallinckrodt pays through the nose for popularity, February 12, 2014). After Questcor the group will carry $3.7bn of debt, an amount that exceeds its market cap.

Shorts fried

Just how overvalued Questcor was perceived to be is illustrated by almost 30% of its stock having been held in short positions, according to March data. Investors thus have another nasty reminder of the perils of shorting stocks in the current market.

Some will argue that Mallinckrodt’s move proves that the bear case was overdone, but nothing alters the fact that Questcor’s business is extremely risky and opportunistic. The company’s only marketed drug, Acthar, is decades off patent and had been acquired for a mere $100,000 before being repositioned for use in orphan diseases at a hugely inflated price.

Quite apart from the ethical questions raised here, the company has also faced pressure from healthcare insurers and a US Attorney's Office investigation into its promotional practices. It also has to contend with shareholder litigation, and an antitrust lawsuit filed by Retrophin, a competitor. UBS analysts expressed surprise at Mallinckrodt’s desire to “step into such a controversial, polarising name”.

The competitive threat to Acthar is considerable, though neither Retrophin nor Cerium Pharmaceuticals, which hold rights to near-identical projects, appear to have done any clinical work yet. For its part, Mallinckrodt insists that the due diligence it carried out on Questcor was bigger and broader than anything it had ever done before.

Mallinckrodt investors must pray that this is not mere hyperbole. Acthar sold $761m last year, but, assuming that its orphan exclusivity expires in 2017, consensus forecasts yield a product NPV of just $2.1bn, EvaluatePharma estimates.

Stretched

And if the Questcor valuation is stretched, so is Mallinckrodt’s net gearing, at around five times earnings before interest, tax, depreciation and amortisation. Through Barclays a senior secured term loan facility and senior debt have been arranged, and given the risk Mallinckrodt is presumably having to pay a sky-high interest rate.

The group has not disclosed details, but admits that the term loan in particular will result in “interest rate expense being higher than what we were able to deal with” earlier. It aims to pay down the high-interest debt as quickly as possible; post-Questcor net gearing will represent “kind of a high water mark”, it says, receding next year as cash flows kick in.

Of course, Mallinckrodt is able to play fast and loose largely thanks to the tax-friendly Irish domicile it acquired with Cadence. It hopes to cut Questcor’s tax rate – currently in the low to mid-30% range – by around 10 points.

That said, it cannot be denied that the Questcor acquisition flies in the face of the investor soul-searching and pullback in the Nasdaq biotech index that had taken place after the pricing challenge to Gilead’s hepatitis C drug Sovaldi.

But then, perhaps mid-tier pharma companies operate in a world of their own. For now, Mallinckrodt insists that Questcor is the next step along its path to becoming a “top-quartile specialty pharmaceutical company”.

Deal bankers pitching overpriced assets that broadly tick the specialty pharma box will have taken note.

To contact the writer of this story email Jacob Plieth in London at jacobp@epvantage.com or follow @JacobEPVantage on Twitter

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