Is There a Lesson to Be Learned in Mallinckrodt's Questcor Deal?

In the bull/bear battle, few biotech companies have been as great a lightning rod for debate as Questcor (NASDAQ: QCOR.DL  ) .

Short-sellers have been vocal opponents of the company for years, believing that its reliance on a decades-old, arguably over priced drug would eventually relegate it to the dustbin. Those fears have been countered by shareholders convinced that Questcor's Acthar is an important drug with plenty of room to grow.

Over the weekend, Mallinckrodt (NYSE: MNK  ) weighed in with its own opinion, agreeing to acquire Questcor in a deal worth more than $5.5 billion. That judgment serves as a not-so-gentle reminder of the risks facing short-sellers. 

MNK Chart

MNK data by YCharts.

Drinking the Kool-Aid
Short-sellers' stake in Questcor was unmistakably massive. Sellers were holding 38% of Questcor's shares available for trading, otherwise known as its share float, short as of mid March. That meant absent Mallinckrodt's acquisition, it would have taken five days worth of average daily trading volume to unwind sellers' 17.5 million share bet.

Putting the sheer size of that position in perspective, only 2% of Facebook, 11% of Netflix, and 13% of Keurig Green Mountain's share float are held short. Not even the highly maligned Herbalife boasts a higher short position relative to float than Questcor.

That statistic suggests Questcor's short-sellers had become far too complacent and convinced that Questcor's future was a dead end. And therein lies a lesson for investors: Even when the market is convinced of an outcome, you should still be skeptical.

Who is Mallinckrodt?
Mallinckrodt is the Ireland based former pharmaceutical arm of Covidien (NYSE: COV  ) , a $32 billion medical instruments company. In a bid to unlock Mallinckrodt's value and free it up to invest for faster growth, Covidien spun the company off to investors last summer.

Mallinckrodt's shares have marched steadily higher since, as investors anticipate growth opportunities tied to Xartemis, Mallinckrodt's latest opioid pain killer. The FDA approved Xartemis in March, significantly bolstering Mallinckrodt's 30% market share for DEA schedule II and III controlled opioid pain killers.

Demand for such drugs is climbing as a longer living population ages, requires more surgery, and endures more chronic and post-operative acute pain. As a result, Mallinckrodt's sales have been growing, rising 8% to $540 million in the fourth quarter. Importantly, Mallinckrodt is a highly profitable company, with $0.88 in earnings per share last quarter, and specialty pharmacy operating margin of 36.5%.

Why did Mallinckrodt buy Questcor?
The Questcor deal comes on top of Mallinckrodt's $1.4 billion dollar acquisition of Cadence Pharmaceuticals in March. Both deals boost Mallinckrodt's specialty drug revenue and offset sales headwinds tied to patent expiration for its top selling pain opioid Exalgo.

In this latest deal, Mallinckrodt is handing Questcor investors $30 in cash and 0.897 shares in Mallinckcrodt for each share of Questcor. The deal, which values Questcor at roughly $86 per share, gives investors a roughly 30% premium to Questcor's prior day close and just shy of 50% ownership in the newly combined, more diversified company.

In return, Mallinckrodt gets Questcor's Acthar, a drug approved as a treatment for multiple sclerosis, kidney disease, and rheumatology patients. Last year, Acthar generated net sales of $761 million, up 50% from 2012.

Much of Acthar's recent success has come thanks to a widely successful launch in rheumatology. Last quarter, the number of rheumatology prescriptions written for Acthar jumped 19% from the prior quarter, lifting rheumatology prescriptions to 20% of Acthar's total quarterly prescriptions. As a result, Questcor shipped 28% more vials and reported earnings that were 65% higher last quarter than a year ago.

Fool-worthy final thoughts
Questor generated $5.48 in non-GAAP earnings per share last year, and Mallinckrodt expects that after removing redundant costs and leveraging its tax-friendly Dublin address, the acquisition will be immediately accretive to earnings this year and "significantly" accretive to earnings next year.

If that proves true, this acquisition may serve as a valuable reminder to investors that company specific shortcomings -- both real and imagined -- are only company specific for as long as the company remains independent. Of course, recognizing that may not keep short-sellers from taking on Mallinckrodt -- they're already short 14% of its share float -- but it may help investors remain skeptical of joining with sellers in highly shorted companies that are growing and profitable.

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11/21/2014 4:03 PM
MNK $87.02 Down -0.10 -0.11%
Mallinckrodt plc CAPS Rating: **
QCOR.DL $0.00 Down +0.00 +0.00%
Questcor Pharmaceu… CAPS Rating: **

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