On April 7, 2014, Mallinckrodt Plc, a specialty pharmaceutical company, announced it entered into an agreement to purchase Questcor Pharmaceuticals for approximately $5.6B ($30 in cash and .897 shares of stock per share of Questcor).
“The visual I see is a slow-motion collision of two garbage trucks–and they are just about to meet bumpers.” –Scott McNealy (founder and former CEO of Sun Microsystems)
While McNealy was describing the Hewlett-Packard and Compaq merger, his colorful description applies just as readily to the Mallinckrodt and Questcor merger.
The deal represents an enormous transfer of risk from Questcor shareholders to Mallinckrodt shareholders. In essence, Mallinckrodt is “doubling down” on a controversial product, H.P Acthar Gel, by levering it up by over a billion dollars. Questcor shareholders, on the other hand, are being relieved of risk by receiving a $30-per-share cash payment and a 49.5% ownership stake in a more diversified, albeit highly levered, company.
What will the new Mallinckrodt look like?
As of the latest SEC filings, MNK currently has cash on hand of $334M and long-term debt of $2.2B. Questcor has cash and short-term investments of $336M and long-term debt of $13M.
To pay out the $30-per-share cash portion of the offer, MNK will need $1.8B, which optimistically assumes MNK can use all of its cash on hand and then use debt financing to cover the remaining portion with debt.
The new combined company will have about $3.3B in debt as shown below.
A pro forma consolidated balance sheet for the combined entity would look something like this:
Note: Because of the high degree debt financing employed, the combined entity will have substantial leverage; so much so that upon completion, the merged company will have negative equity.
For Mallinckrodt shareholders this is a serious risk.
Below is a slide taken from Mallinckrodt’s investor presentation on the Questcor merger. I have highlighted in red a key section of the slide.
The slide is correct; the transaction is compelling – if you are a Questcor shareholder. For Mallinckrodt shareholders, take note of the section highlighted in red. The cash flow from Questcor will not be accretive to shareholders right away, since it is being used to pay down debt (again due to the negative equity of the combined entity).
Mallinckrodt is betting, and betting heavily, that Questcor’s revenue stream from H.P. Acthar Gel will remain at its current levels (or grow) for several years.
Just how valid is this assumption?
In 2001, Questcor bought the rights to Acthar, a 60-year-old drug, from Aventis for a paultry $100,000. With aggressive marketing, Questcor was able to turn the drug into a massive profit center.
Now, health insurance companies like Cigna, Aetna, and United Healthcare arebeginning to crack down on their reimbursement payments for H.P. Acthar Gel. Questcor is under investigation by the US Attorney’s offices of the Eastern District of Pennsylvania, Southern District of New York, and Los Angeles as well as the SEC. On top of all that, The New York Times recently reported that Questcor has revealed adverse event data about its top drug for the first time while it likely should have been reporting that data to investors for years. Was the company trying to hide something?
The fact that shareholders in Mallinckrodt now have to trust the fate of a highly levered company to a previously unsuccessful drug that may owe its current sales success to inappropriate, unethical, or even illegal marketing tactics makes Mallinckrodt (MNK) our Dumb Investment of the Week.