Covidien's Mallinckrodt Spin-Off Faces Challenging Environment

On June 28,  Covidien plans to spin off its specialty pharmaceutical segment, Mallinckrodt MNK, as a separate publicly traded company. Covidien shareholders will receive one share of Mallinckrodt for every eight shares of Covidien.

Mallinckrodt's focus on the highly regulated nuclear imaging and controlled substance markets gives it an interesting niche with some barriers to entry, but it is not strong enough to warrant a moat. In our opinion, the firm's best asset is its nuclear imaging business, where it faces minimal competition, but the segment is overshadowed by the company's larger contrast media and generic drug segments, both of which are highly competitive and lack moats. Our fair value estimate is $40 per share, slightly below where the stock is currently trading on a when-issued basis.

 Mallinckrodt Segment Analysis

Source: Morningstar estimates, company reports 

As an independent entity, Mallinckrodt lacks strong competitive advantages and faces minimal organic growth opportunities. The firm's generic business is well established, especially within the pain therapeutic area, but selling generic drugs in developed markets is traditionally an unattractive business with limited product differentiation, significant pricing pressure, and highly volatile sales. Mallinckrodt's focus on the highly regulated pain market and its vertically integrated structure make it slightly more appealing than the average generic manufacturer, but it is still a no-moat, low-margin business that faces significant pricing pressure.

We suspect that with its newfound independence, Mallinckrodt will seek to increase its research and development investments in an effort to build up its branded pharmaceutical business. While we believe the branded pharmaceutical business is more attractive than the generics business, it still faces challenges of its own. The current payer environment has put pressure on branded products, limiting pricing power and driving higher utilization of generics. The high penetration of generic products also creates a high hurdle for innovative new products. New products will need to be significantly more effective or significantly safer to justify their high prices compared with cheaper generic alternatives.

Mallinckrodt's branded business is made up almost entirely by Exalgo, but the drug faces generic competition in July 2014, so Mallinckrodt will essentially be attempting to build a branded pain business from scratch. The small size means it lacks the extensive salesforce and infrastructure that its rivals have, which we believe will weigh on its ability to push new products. The sales it does complete are likely to be lower margin than rivals as it won't be able to get as much leverage out of its salesforce.

We believe the firm's strongest business is its nuclear imaging segment, which sells nuclear imaging agents and generators and accounts for about 25% of company sales. We believe it is the only segment that would warrant a moat as the firm is one of the only players in the niche market. The sensitivity of nuclear products leads customers to stick with established and trustworthy suppliers that have nuclear logistics experience and good relationships with reactors, making it very difficult for new competitors to enter the space. Unfortunately for Mallinckrodt, this mature business has minimal growth opportunities, and we expect low-single-digit growth going forward.

Key Investment Considerations
Because of prevalent abuse, pain medications face strict regulations. Restrictions of supply, such as quotas, limit new entrants and help entrenched players such as Mallinckrodt that are trusted with the government's quota, but any regulations that reduce volumes would hurt Mallinckrodt.

Mallinckrodt is looking to invest its way into becoming a major player in branded pain products. We have mixed opinions of this proposition as the branded pain market faces numerous challenges, but it is still likely to be more lucrative than generics.

Sales in the firm's generics business can be very volatile because of first-to-file 180-day exclusivity periods that occasionally allow a firm to launch the first nonauthorized generic and earn excess returns for a short period.

Bulls Say

• Mallinckrodt's established reputation in highly sensitive nuclear products makes it unlikely for new entrants to steal business from Mallinckrodt.
• The firm is consistently awarded a significant share of the U.S. Drug Enforcement Administration's quota for controlled substances.
• Mallinckrodt is shifting its focus to growing its higher gross margin branded pharmaceutical business.
• The firm's Ireland headquarters could make it an attractive takeover target, as we saw in the Actavis and Warner Chilcott merger.

Bears Say

• Mallinckrodt's contrast media and delivery systems segment is a no-moat business that is experiencing increased competition and pricing pressure, leading to declining sales.
• Mallinckrodt plans to invest heavily in its specialty branded pharmaceutical business, where it will be going up against better-positioned competitors.
• Opioids are widely perceived to be overprescribed and abused, so the market is likely to face increased restrictions from government regulators or health-care providers that could weigh on volumes.
• The firm's generics business competes against many larger competitors that have scale advantages over Mallinckrodt.

Valuation
Our fair value estimate for Mallinckrodt is $40 per share. This assumes a share count of 60 million shares, based on the proposed ratio of one share of Mallinckrodt for every eight shares of Covidien. The firm is in for a challenging 2014 when Exalgo comes of patent and it will see the end of its 180-day exclusivity on generic Concerta. The exclusivity period will provide a nice boost to 2013 results but will lead to a decline in the generics segment in 2014. Starting in 2015, we expect the firm to return to a more steady and normalized growth trajectory. Our five-year compound annual sales forecast calls for 3% annual growth.

We expect the firm's operating margin to take a hit in the near term but expand over the long term. The combination of increased R&D spending and the loss of high-margin Exalgo will weigh on the firm's operating margin in 2014 and 2015, but the firm should eventually see higher-than-historic margins as branded pharma products make up an increased portion of the business.

Mallinckrodt management issued a tax rate forecast calling for a companywide tax rate of 28%-32% for its first full quarter on the market. The firm has not issued long-term guidance, but as it is an Ireland-based firm, we would expect the tax rate to fall to 22% by 2018, which would be in line with Covidien's companywide tax rate.

Given the recent consolidation in specialty pharma and the increased focus by companies on tax rates, we think Mallinckrodt's Ireland headquarters makes it an attractive target for larger firms. We would not be surprised to see it trade at a premium to its intrinsic value as a stand-alone business because of investors pricing in the chance of acquisition.

Moat
We do not believe Mallinckrodt warrants an economic moat. The firm's largest segment, generics and API, makes up around 40% of company sales and has unattractive economics. The generics business sells commodity products competing on price. Periodically the industry offers excess returns when a firm is given first-to-file status and 180 days of exclusivity, but it is highly volatile and unpredictable to count on locking up exclusivity over the long term. The highly regulated nature of the pain market provides a slight barrier for new competitors, but we do not believe it is enough to warrant an economic moat. We believe the quota system puts a floor under prices, as it restricts firms from flooding the market with cheaper products, but it does not restrict supply enough to cause a shortage and allow Mallinckrodt to earn excess returns. We traditionally have awarded moats in the generics industry to firms that possess cost advantages due to extensive scale relative to competitors. With less than $1 billion in sales, Mallinckrodt's generics business is much smaller than the multiple billions of dollars of sales that narrow-moat competitors Mylan, Teva, and Actavis record in just their U.S. generics businesses each year, putting Mallinckrodt at a severe disadvantage.

The firm's branded pharmaceutical business could eventually warrant an economic moat, but given its heavy reliance on Exalgo, which has a limited remaining life span, we do not believe it deserves one at this time. We typically expect to see a diversified portfolio of patent products, or at least one product with extremely high advantages, before we would award a pharmaceutical firm a moat. Even if the firm's late-stage pipeline portfolio is approved, the offerings are largely me-too products that will face extensive competition from other branded and generic pain medications. We do not believe any offer a revolutionary treatment option that would command a premium price to the competition.

The medical imaging segment, consisting of contrast media and nuclear imaging, is similarly mixed. The contrast media segment is a no-moat commodity business with declining sales as a result of increased competition and pricing pressure. However, we believe the nuclear imaging business is the firm's strongest and would warrant a narrow economic moat if it were a stand-alone business.

The segment's revenue is largely derived from selling generators that convert molybdenum-99 into technetium-99 to be used in nuclear imaging tests. The firm is one of only two manufacturers in the United States and one of only three in Europe, so it faces very limited competition.

Moat Trend
We give Mallinckrodt a stable moat trend. The four markets the company competes in are very mature, and the competitive dynamics are slow to change. We believe the generic and API business has a stable trend, as strict regulations and government-assigned quotas surrounding controlled substances reduce the ability for any competitor to significantly increase or decrease its competitive advantages. Although the firm is working on its pipeline in an attempt to strengthen its competitive advantages in its branded pharmaceuticals business, we think it is much too early to award the firm a moat, especially with Exalgo facing generic competition in 2014. Similarly, the nuclear imaging business is very stable and the firm's competitive position isn't changing. The only segment without a stable trend is the contrast imaging business, where the firm's commoditized product is facing severe pricing pressure, warranting a negative moat trend.

Risk
The nuclear products and controlled substances markets face significant regulations, so Mallinckrodt could be positively or negatively affected by changes to laws or regulations. On the pharmaceutical side, regulation regarding abuse-resistance products is unpredictable and is rapidly changing. The U.S. Food and Drug Administration recently ruled that generic firms would not be allowed to make generic versions of Purdue Pharma's blockbuster pain medication OxyContin because the formulation that was off patent did not contain abuse-resistant technology that made it tougher to crush. The ruling locked generic makers, such as Mallinckrodt, out of a lucrative opportunity. Shortly after the OxyContin ruling, Endo Health Solutions lost its attempt to earn a similar ruling regarding the upcoming patent loss of its Opana ER formulations that also lacked abuse-resistant technology, highlighting the unpredictability of this heavily regulated market.

Financial Health
Mallinckrodt has taken on $900 million of debt, or approximately 2.2 times our 2013 adjusted EBITDA estimate, of which it will retain $170 million and pass the rest on to Covidien. Sales in the generics business can be lumpy around new generic launches, but as a whole, the firm's cash flows are fairly stable and predictable, and we do not anticipate it having any trouble repaying its debt. In fact, we would not be surprised to see the firm take on even more debt to acquire products or businesses to improve its branded pharmaceuticals business.

Management
Mallinckrodt will be run by CEO Mark Trudeau, who joined Covidien in February 2012. We think his experience makes him a strong fit for the position. Before joining Covidien, he was CEO of Bayer Healthcare's U.S. Pharmaceutical business and worked in the firm's global specialty pharmaceuticals business. Given Mallinckrodt's diverse operations, experience at a firm like Bayer, which also has a broad reach across many health-care segments including contrast agents, will be highly valuable. With a very limited track record to assess management's capital allocation and minimal insight into previous operating results, we default to a standard stewardship rating.