Mallinckrodt Plc (MNKT)

[XenaLives]

Interesting summary, not saying disagree or agree:

Lawsuit Liabilities Will Do In Mallinckrodt
Sep. 13, 2019 12:42 PM ET|58 comments | About: Mallinckrodt plc (MNK)
ASB Capital
ASB Capital
Value, special situations, contrarian
(301 followers)
Summary
This highly indebted company faces massive liabilities from lawsuits.

Current settlements and bond prices show creditors do not expect to be paid in full.

Trouble in existing business lines may make things worse.

This company will probably default on debt in as little as seven months.

Mallinckrodt (MNK) is a deeply-indebted drug manufacturer with what appear to be insurmountable problems. The past month has seen rumors of an impending bankruptcy turn into news of an asset sale, and the stock's price fell by two-thirds and then doubles. As the dust settles and we analyze the company's contingent liabilities from lawsuits and regulatory actions and consider the likelihood of declining revenue from several products, the most important question about a bankruptcy appears to be "when," not "if."

Background
Mallinckrodt is a drug company that has grown through debt-fueled acquisitions rather than research and development. Originally spun off from Covidien, Plc, in 2013 the company acquired and Irish subsidiary and inverted its citizenship in order to take advantage of Ireland's lower tax rate. In 2014, Mallinckrodt took advantage of the low tax rate to be an advantageous purchaser of Questor for $5.6 billion. Questor brought with it one of MNK's highest revenue products, the controversial drug Acthar. Questor and Mallinckrodt have raised the price of Acthar from $40 per dose to over $34,000, which has attracted opporbirum and was the subject of an FTC settlement. As if that weren't enough, one of the company's other biggest products has been widely-abused prescription opioids.

Throughout the past five years, Mallinckrodt has made a lot of money selling opioids and extremely high-priced drugs. For 2016-2018, the company produced $1,18 billion, $727 million and $665 million in cash from operations, and repurchased $653 million worth of stock in 2016 when shares were more than $50 and then $652 million with share prices from the $40s to the $20s (see Annual Report, page 82). In 2018, and through 2019, the company has focused on debt reduction as the most recent 10Q shows total debt being reduced by $550 million. [Note that $700 million of notes due in April 2020 become current, so add that back to get the total number.] For the reasons described below, I believe this debt reduction will not be enough to satisfy these debts and contingent liabilities that are certainly coming into focus.

For those seeking more detail on Mallinckrodt's current business and future prospects, I want to recommend Zhiyuan Sun's article Mallinckrodt Plc: Price Gouging Drug Company Due For A Dead Cat Rebound.

Opioid Liabilities
As described in the articles above, Mallinckrodt has significant exposure to opioid lawsuits. The Wall Street Journal said in August, "Mallinckrodt's opioids represented 38% of the total prescription opioids sold in the U.S. from 2006 to 2012, making it the country's single largest manufacturer of prescription opioid pills during that period." Pages 18 and 19 of the most recent 10Q describe over 2000 lawsuits, but the conclusion of the description says simply, "Since these lawsuits are in early stages, the Company is unable to predict outcomes or estimate a range of reasonably possible losses." That means that the company's financial statements take no reserve for liabilities related to these suits, the job of predicting a range of losses falls to analysts.

We have two data points to estimate MNK's exposure. First, the Sackler family which owns opioid manufacturer Purdue Pharmaceuticals has apparently offered a global settlement in the range of $10-12 billion. Importantly, this settlement includes a contribution from the multi-billion dollar fortune of up between $3 and $4.5 billion. Based on the Wall Street Journal's information, MNK sold almost twice as large a share of US opioids, but apparently entered the business much later. Without other information, I would net out the larger market share against the shorter time frame and say that MNK could be on the hook for $10 billion, but there are some important reasons why this case is distinguishable.

Last week, Mallinckrodt settled cases with two Ohio counties for $24 million in cash plus $6 million in benefits in the form of drugs to be supplied in the future. Taking a rough estimate, these counties have a combined population of just under 2 million, which is about 2/3 of 1% of the US population. So a reasonable guess would be that total comparable settlements would be 150 times $24 million in cash, or $1.2 billion. That back-of-the-envelope number is quite far from our $10 billion figure indeed!

The two different implied settlement amounts are so far apart for an important reason described by the plaintiff's lawyers: settling now gives them "protection in any future insolvency proceeding by Mallinckrodt." So the most important distinction is that Purdue settlement is being made by a solvent defendant and the Mallinckrodt settlement is being made by a potentially insolvent one. That means that the total amount of liabilities should be far higher than simply multiplying the amount of the settlement across the whole range of plaintiffs. Rather, this is the discount that earliest plaintiff is willing to take in order to be free of the risk that any recovery would be greatly diminished and remote in time. I estimate this discount to be anywhere between a 50% to 24% haircut, meaning the real estimate of liabilities implied by the settlement could be anywhere from $2.4 billion to $4.8 billion!

Settling your liabilities at a steep discount sounds like a great deal for shareholders, right? Wrong. What it means is that if Mallinckrodt's prospects ever improve, later plaintiffs will be bolder and insist on taking the value of any and all appreciation. That is to say, they won't be willing to settle for a fraction and leave something for shareholders.

Other Contingent Liabilities

But wait - there's more! As described in the quarterly report, Mallinckrodt also faces significant liabilities from other suits including one from the Centers for Medicare & Medicaid Services and certain states related to the pricing of Acthar. A recent Bank of America Merrill Lynch note estimated the liability from these overcharging suits at $250 million (but they also believe opioid liabilities could be as low as $750 million to be paid out over 20 years).

Bond Prices
So far, we've talked about two sources of liabilities not reflected in the plain, vanilla financial statements. For the reasons described in the Mr. Sun's article, I believe Mallinckrodt's future revenues from existing business will decline significantly. Falling revenues and growing debt do not make for happy bondholders.

Of Mallinckrodt's $5.5 billion in balance sheet debt, over $1.9 billion is held in two secured bank loans. That is to say that these debts have the right to be paid in full, first from all the companies assets (or more precisely, all pledged assets) before any other creditors get a dollar. Of the remaining $3.6 billion in bond debt, all of it trades at a significant discount.

The company's $700 million of bond debt due in April 2020 traded for 72 cents on the dollar as recently as September 12. This reflects a very high perception of bankruptcy because someone who bought the debt today at that price could earn interest and then receive the whole principle in only seven months, representing a gain of 50% in less than a year! Bulls point to the fact that the company has more than $500 million in cash on hand and can be expected to produce meaningful free cash flow (perhaps $300 million?) over the next six months. In addition, the company sold an asset last week for $135 million in cash plus future payments.

Rather than look at this large pile of cash and think the company has enough to repay its upcoming bond debt, I take the other tack. I believe that knowing they will not be able to repay on time and anticipating a bankruptcy, management is "hoarding cash," trying to take advantage of financing that was made available when the company appeared solvent. This explains why the company drew $400 million on its revolving credit line after the end of the second quarter (as described in the 10Q, page 39).

Longer dated debt trades at remarkable discounts. Bonds due in 2025 were available for 33 cents on the dollar on September 12, which reflects additional uncertainty around "Loss of Exclusivity" events so aptly described in Sun's article.

Late Breaking News
As I write this article, the company announced that in a retrospective study, it found that its own drug Acthar might be a cost-effective treatment for multiple sclerosis. I'm not qualified to evaluate the medical value of this announcement, but the timing doesn't pass the smell test. This drug has been used since the 1950s, it was acquired by Questor in 2001 when they started raising prices, and it's been owned by Mallinckrodt since 2014. Do you really believe that they only now discovered a new use for it?

Conclusion
For the foregoing reasons, I believe that Mallinckrodt's liabilities are far higher than reported in financial statements. I do not believe the company will be able to pay them, and facing mounting liabilities and the prospect of shrinking revenues, I expect the company to file for bankruptcy before its April 2020 bonds come due. I am short shares of Mallinckrodt (MNK).

Disclosure: I am/we are short MNK. 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.

https://seekingalpha.com/article/4291448-lawsuit-liabilities-will-mallinckrodt