Mallinckrodt plc Takes a Big Swing for Growth

Facing declining market share in its core generic controlled substance (painkillers) market and holding the valuable asset of an Irish tax domicile, Mallinckrodt plc (NYSE: MNK  ) has aggressively put its balance sheet to work. First the company announced a $1.3 billion deal for Cadence Pharmaceuticals (NASDAQ: CADX  ) and its hospital-centered Ofirmev product (injected acetamenophen). Now the company is taking an even bigger swing – announcing a $5.6 billion deal for controversial Questcor (NASDAQ: QCOR  ) and its lead drug Achtar.

If Mallinckrodt can steer Questcor past the rocks that short sellers have been loudly claiming are in the company's path, this deal could double Mallinckrodt's earnings in relatively short order. If the short sellers are proven right about the many and varied problems of Questcor and Achtar, Mallinckrodt's shareholders will pay the price.

The deal to be
Mallinckrodt and Questcor announced Monday morning that they had reached an agreement on a $5.6 billion cash-and-stock deal. This deal values Questcor at $86.10 as of the deal announcement, a 27% premium to Friday's close and very nearly matching the 52-week high for a stock that is up over 150% over the past year. Questcor shareholders will receive $30 in cash per share, as well as 0.897 shares of Mallinckrodt, making them 49.5% owners of the combined company.

What Mallinckrodt is getting
In buying Questcor, Mallinckrodt is acquiring almost $800 million in revenue, $440 million in operating income and $334 million in 2013 free cash flow. Revenue, earnings, and cash flow have been growing at a rapid clip at Questcor in recent years, with a three-year revenue CAGR of 90% and a 100% growth rate for operating income.

Virtually all (95%) of Questcor's revenue comes from the highly controversial compound Acthar Gel (or Acthar). This injected drug is a complex mix of adrenocorticotropic hormone (or ACTH) and other peptides that has 19 FDA-approved indications. Acthar is used to treat exacerbations of multiple sclerosis, infantile spasms, and nephrotic syndrome and has more recently seen growing use in rheumatology indications like rheumatoid arthritis and lupus.

I could fill a week's worth of articles detailing the controversies over and about Acthar. For starters, there is not a lot of clinical data supporting many of the indicated uses, and payers (Aetna most notably) have tried to use that to deny reimbursement. A far bigger row concerns the price of the drug – once sold for about $50/vial, Questcor now charges around $32,000/vial (though rebates can reduce the effective price). Questcor argues that the drug is difficult to manufacture (and that's certainly true to a point), but this has become "Exhibit A" for many activists arguing that the government needs to step in and restrain drug prices.

Those aren't the only issues. The DOJ is investigating Questcor for the company's promotional practices, and similar investigations have led to large financial settlements from other drug companies in the past. Potentially more damning, but far less proven, short sellers have claimed that their evaluations of the drug have shown little-to-no active ingredient (ACTH) in Acthar.

The DOJ investigation looms as a real threat, and one where I doubt Mallinckrodt has any particular insight (it is not as though they could call the DOJ and ask about the investigation). Insofar as the real contents of Acthar go, though, I would imagine that Mallinckrodt has already evaluated this potential claim, as it is not a particularly difficult issue to confirm (though Acthar contains a complicated mix of peptides that alter the PK profile).

What this could mean for Mallinckrodt
Retrophin is working on its own version of ACTH (RE-034), but I doubt that any new entrants would be eager to seriously disrupt the pricing that Acthar Gel presently enjoys. Likewise, moves from payers or legislators to impact pricing would be difficult at best.

Assuming that the deal goes through, Mallinckrodt will be able to reap meaningful back-office synergies from this deal and run those rich Acthar income streams through its lower Irish tax basis. Based on current expectations for Questcor, modest synergy assumptions, and the tax differences, I estimate that Questcor could add 85% to 100% to Mallinckrodt earnings in 2015 and 2016.

That's incredible leverage from an M&A transaction, but investors should demand exceptional returns for the risks involved. The ramifications of that DOJ investigation are still unknown and while the future sales of Acthar are in question, the reality of debt payments to fund this deal will be very real.

The Bottom Line
Mallinckrodt was a fairly sleepy company split between generic pain medications and medical imaging. Cadence should add a little extra oomph to its hospital sales efforts, while Questcor brings in a very large (if controversial) specialty drug with multiple potential growth indications still in the future. With this deal, though, Mallinckrodt becomes a much riskier company with substantial debt. That's a big change in its basic nature, and one that may lead shareholders to consider whether the upside potential from the Questcor deal is worth the added risk and leverage.

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