The charts did not copy over well.  For a cleaner version with the graphics please see the link below.  

http://www.scribd.com/doc/155315855/MNK?secret_password=18f68twgipiwk5hkypc7

Thesis

We believe Mallinckrodt plc (MNK) is an attractive investment opportunity.  As a recent $2.5 billion market cap specialty pharmaceutical spin-out from Covidien (COV), a $29 billion market cap S&P 500 medical device company, MNK’s stock has exhibited classic post spin off technical selling. MNK’s shares currently trade at a significant discount to specialty pharmaceuticals peers in spite of the company’s attractive end markets and pipeline of promising abuse resistant pain killers. MNK is a likely acquisition target for many of its larger competitors as it has a market capitalization that is small enough to digest, dominant positions in niche markets, and a highly free cash generative business. Furthermore, as an Irish domiciled company, MNK is an interesting acquisition target as a means for the acquirer to reduce their long term tax rate. Management incentives are well aligned at the current stock price given the $44/share strike price for management’s options acquired as part of the spin off. We expect MNK shares to see significant upside from the current share price of $43.50/share as the technical selling related to the spin off ends, the company hosts an analyst day in the fall providing more color on its product pipeline, the company gains FDA approval for its new pain killers, the company is “discovered” by specialty pharmaceuticals analysts, and the company is ultimately acquired by one of its much larger peers.

Overview

Mallinckrodt Pharmaceuticals was spun off from Covidien on June 30^th 2013. As a large medical devices company, Covidien viewed its pharmaceuticals and medical imaging businesses as low growth cash cows that could be used to fund growth in the devices businesses.

Mallinckrodt’s shares have seen significant technical selling related to the spin off -- shares started trading initially at $49/share in the when issued market before falling to $41.50/share last week. Covidien’s shareholders have largely ignored the business as they were significantly more interested in the medical device business and viewed the MNK business as a drag on revenue and earnings growth. We expect most Covidien shareholders to sell their shares. In addition, COV was part of the S&P 500, while MNK with only 2.5B market cap was not included in the index, therefore, index holders were forced to sell their MNK shares.  Some natural buyers of orphan spin offs like special situation and event driven funds are hesitant to touch MNK given the specialized nature of generics and pharmaceuticals.  Therefore the stock has underperformed since when issued trading began as the shareholder base has undergone a change.

MNK operates in 2 principal business lines of roughly equal size: specialty pharmaceuticals and global medical imaging. Each of the company’s business lines are highly regulated business areas where MNK has a strong competitive position. In specialty pharma, MNK deals in controlled substances where the government has strict quotas on the supply of the active pharmaceutical ingredients that can be manufactured as well as significant limitations on foreign imports. The nuclear imaging business has relatively limited competition given the need to source radioactive materials and the very limited number of suppliers of these materials. 

Capitalization

Specialty Pharmaceuticals

MNK’s specialty pharmaceuticals segment develops, manufactures and sells branded drugs including Exalgo for the treatment of moderate to severe pain in opiod tolerant patients and Gablofen which are injections indicated for use in the management of severe spasticity of cerebral or spinal origin. MNK’s pharmaceuticals segment also develops, manufactures and sells generic drugs most of which contain US DEA Schedule II or III controlled substances.

MNK has 40% share of the DEA quota for controlled substances for active pharmaceutical ingredients (API).  For opiate oral solid tablets, MNK has a 32% market share.  The need to obtain DEA quotas effectively acts as a moat ensuring limited competition for MNK’s products.  MNK is attempting to capitalize on their expertise and strength in controlled substances to expand their footprint now that they are able to operate as an independent business (in contrast to being run as a cash generation business while part of COV). 

Concerta

On December 28^th, 2012, MNK received approval for the generic versions of the 27mg, 36mg and 54mg strengths of Concerta – an attention deficit hyperactivity disorder (ADHD) drug.  Concerta had sales of $1.6B drug including both generic and branded formulations in 2012.  JNJ is the branded manufacturer for Concerta while Actavis (ACT) markets a generic version through an exclusive agreement with JNJ that has the vast majority of market share.  MNK launched the generic 27mg tablet on December 31^st, 2012.  As the first generic to receive approval on these dosage strengths MNK has 180-day exclusivity for each strength following their first commercial launch.  In February 2013 MNK submitted an application for the 18mg strength tablet.

The overall market contracts in the summer due to the end of the school year for children. 

Source: IMS

MNK expects sales to be at least $125M for generic Concerta in FY2013.  Sales of generic Concerta were $9M in the quarter ending Dec 2012 and $62M for the quarter ending March 2013.  Sales may not match with actual demand as manufacturers often sell a bolus into the channel to ensure that pharmacies are well stocked.  IMS script data (a third party vender) is a more reliable gauge of end user demand. 

Source: Company presentations

MNK has steadily gained share of the Concerta market, especially following the March 25^th launch of the 36mg and 54mg strength tablets. 

Source: IMS

On July 10^th, 2013 UCB’s Kudco announced that they had received approval for the 18mg and 27mg formulation for methylphenidate hydrochloride (also known as Concerta).  UCB also received tentative approval for the 36mg and 54mg pills.  (http://tinyurl.com/lgd8h6v).  MNK holds 180-day exclusivity on the 36 and 54mg pills which will expire on September 22, 2013 (181 days from the March 25^th launch), at which point UCB will be able to market their generic versions.

TEVA and IPXL reached a settlement with JNJ allowing them to enter the market with their generic Concerta on July 14, 2013 (http://tinyurl.com/l3txca5).  IPXL has submitted the ANDA (generic application) filing, and TEVA will commercialize the product once approval is obtained.  On March 4^th, 2013 IPXL received a second Form 483 letter from the FDA for their Hayward manufacturing facility which is holding up approval for their generic Concerta (http://tinyurl.com/nd8w6bj).  IPXL has publicly stated that they will require resolution of the 483 in order to obtain FDA approval for their generic Concerta.  The Form 483 will likely take a year to resolve, if not longer.  Past history would suggest that IPXL has serious problems at their facility, as this is the second letter that they have received. 

We believe Adderall XR is a reasonable comp for how the Concerta market will play out.  Adderall XR is also an ADHD medication.  Global Pharm Corp (an IPXL subsidiary) and TEVA sell generic of Adderall XR but they receive supply from Shire who manufactures the branded product.  Therefore the market has been constrained as only ACT has been able to truly price and supply product as they wish.  Nevertheless sales have been remarkably stable as supply is constrained and there is limited competition.  Importantly, as supply is limited, pricing is stable.  We believe that Concerta will have similar dynamics.  DEA quotas for these products are complicated processes, and therefore we expect the generic companies will be unwilling to discount to gain market share – especially if they are constrained by supply.  Importantly, UCB’s generic division sells relatively few products.  Kremers Urban only sells 21 products of these only 2 are on the DEA controlled substances list with quotas – a generic of Tussionex which contains hydrocodone, and the Concerta generic (methyphenidate).  UCB, the parent company of Kremers Urban manufactures branded Tussionex so this generic is likely an authorized generic.  Therefore it appears that the Concerta generic is Kremer’s first “true” generic for a product that requires DEA quota.   However, UCB does sell Metadate CD (http://www.ucb.com/products/product-list/cns/metadate) for ADHD which does contain methylphenidate as well, the same active ingredient as Concerta.  Thus DEA quota may not be a substantial issue for Kremers.  However, their lack of scale in generics may be a liability in terms of getting uptake in the channel.  

Source: IMS

Source: IMS

We model share erosion for MNK due to the introduction of Kremers Urban into the market.  And additional market share erosion from the entrance of TEVA/IPXL in 2014.  However, we believe that revenues from generic Concerta can be flat to stable in FY2014 relative to FY2013.  This is largely due to the fact that the launch was still ongoing in FY2013 and what we believe will be limited discounting with the entrance of new players.  Typical generic prices for simple oral tablets can plummet to 5-10% of the branded price.  However, this is due to the entrance of multiple manufacturers (some products can have more than 10), and the recognition that there is a very small window to capture market share and realize a return on the investment.  In contrast, for markets where the product is more difficult to make, and there is a DEA quota, and there is expected to be little competition, such as Adderall XR or Concerta, we believe pricing behavior is much more rational as companies maximize the value of the opportunity by being disciplined on price and maintaining a market with meaningful revenues for all players for many years. 

Source: IMS and internal projections

We assume that there is continued small market growth of 1% a year in total. Concerta scripts have been averaging >2% for the past 2 years.  We model market share loss of MNK following the introduction of UCB generics, but assume that it will continue to maintain the 2^nd largest share – this is consistent with most generic markets where the order of entry determines the long term market share rankings.  We assume further erosion of market share with the entrance of IPXL/TEVA in late April 2014.  We believe this is appropriate as it will take at least a year to solve the manufacturing problems at their Hayward facility, and there may be additional review time for the generic Concerta application. 

For pricing we assume continued price erosion, with realized revenue per script of 45% of the branded at the end of 2014 following the introduction of IPXL/TEVA.

Source: Price Rx, IMS and internal projections

Specialty Pharmaceutical Pipeline

MNK has 3 branded products in development and 5 generic applications.  MNK-795 and MNK-155 are the most important drugs in the pipeline.  Each of these products is expected to have several hundred million in sales potential. MNK submitted an NDA for MNK-795 to the FDA in May 2013 and should receive an acceptance on the filing by July.  If the filing is accepted, the FDA will issue its approval decision in May 2014. MNK-155 entered Phase III clinical development in the 1H of FY2013.  According to clinicaltrials.gov, the trials are expected to read out in October 2013 (http://tinyurl.com/mkb5tj6 and http://tinyurl.com/kpr7wp8).  We anticipate if the trials are successful, a potential filing in late CY2013 with a possible approval by late CY2014. MNK-395 is a PENNSAID follow on product, and would have a smaller market potential. 

MNK-795 is a novel reformulation of existing controlled substance analgesic combination products that may be indicated for acute, moderate to severe pain. MNK-795 was formulated as a low dose product to fulfill an unmet clinical need in the market and also has certain abuse-deterrent characteristics. The MNK-795 NDA was submitted to the FDA, in May 2013, and we are awaiting official certification of acceptance for the filing. The formulation uses the patented Depomed, Inc. (“Depomed”) Acuform™ drug-delivery technology licensed in 2009.

MNK-155 is a novel reformulation of a different combination of controlled substance analgesic products that may be indicated for acute, moderate to severe pain. MNK-155 was formulated as a low-dose product to fulfill an unmet clinical need in the market and also has certain abuse-deterrent characteristics. MNK-155 entered Phase III clinical development in the first half of fiscal 2013. The formulation uses the patented Depomed Acuform drug-delivery technology licensed in 2009.

Source: Company Presentations

MNK has stated that MNK-795 and MNK-155 are combination pain products.  Thus these are likely reformulations of Percocet and Vicodin.  The company described the products as follows at the recent Goldman Sachs Healthcare conference:

“MNK795 and 155 will be combination pain products that, if they're approved, will be indicated for acute moderate pain. Acute moderate pain is the largest by-prescription volume category in virtually the entire US pharmaceutical industry, at over 200 million prescriptions. Virtually all of those 200 million prescriptions are currently written for short-acting, non-abuse deterrent products. These would be generic forms of Percocet and Vicodin, for example.

Our formulations going to be pretty different in the sense that it'll be a combination low-dose opioid with another analgesic using extended release technology plus abuse deterrent technology. So, we think we are likely to be the first, and perhaps the only for a while, company that's going to come in with that type of an offering into a very large market opportunity.

And so, both 795 and 155 are similar products in their formulation, but they're different combinations of opioids. So, we believe we're going to cover the entire landscape of that acute moderate space. And we think the likelihood of these things coming to market is pretty high. The reason for that is that the combinations, the active ingredients, are well known, well known to the FDA. We've been manufacturing them in combination for quite some time. The extended release technology is coming from our Depomed Accuform license that we engaged in a couple of years ago with Depomend. This is also technology that's well understood and characterized by the FDA as there have been a number of products using that technology that have come to market in other therapeutic areas.

So, we think the likelihood of these products coming to market is pretty high, and we filed MNK795 just recently with the FDA. We would expect, within the next 60 days or so, we'll get a PDUFA date, but we're fully expecting that we'll have the opportunity to bring 795 to the market some time towards the first half of calendar 2014.

MNK155, which we think is a slightly larger opportunity than 795, is about one year behind in its development, but it's almost identical development. And so, we'll have a very good idea about the future of 155 once we know where 795 is heading, and we'll know that in the next few days or so. So, we see both of these products as having the potential for multi-hundred million dollar revenue eh if we can execute them effectively over the next couple of years.”

Source: MNK at GS Conference 2013

Depomed’s (DEPO) Acuform technology has been used in a number of FDA approved products including Gralise, Glumetza, Janumet XR and Nucynta ER.  This technology allows the tablet to swell and thus stay in the stomach for 8-10 hours, thus allowing for less frequent dosing of drugs. 

We believe that MNK-795 and MNK-155 are likely extended-release and abuse-deterrent versions of Percocet and Vicodin.  We believe that the abuse-deterrent features will be more important than the less frequent dosing. 

Percocet is dosed every 6 hours as needed, while Vicodin is dosed every 4-6 hours.  Once a day dosing is usually not an important differentiator for pain medications as other therapeutic classes as patient do not mind taking pills more often if it makes them feel better. 

The FDA in January of this year issued a draft guidance on abuse-resistant medications (http://tinyurl.com/aksmtas).  Draft guidance documents are effectively final determinations by the FDA for their thinking on certain topics - many draft guidances never are converted into final guidances.  As the guidance states, the "FDA considers the development of these products [abuse-deterrent opioids] a high public health priority."  The FDA guidance includes 4 tiers of abuse-deterrent product labeling:

Tier 1: The Product is Formulated with Physicochemical Barriers to Abuse

Tier 2: The Product is Expected to Reduce or Block Effect of the Opioid When the Product is Manipulated

Tier 3: The Product is Expected to Result in a Meaningful Reduction in Abuse

Tier 4: The Product has Demonstrated Reduced Abuse in the Community

MNK stated at the GS conference that they have done the abuse-deterrent tests listed in the guidance document.  They believe they have done the tests to get at least a couple of tiers of the labeling.  In their abuse tests, when they try to extract the drug, their formulation gums up and makes it more difficult for people who abuse opioids to get the active ingredient.  If MNK is able to get an abuse deterrent labeling for MNK-795, we believe that the commercial potential of this agent will be very robust.

In April, the FDA approved abuse-deterrent labeling for reformulated OxyContin which was already on the market (http://tinyurl.com/c7gu4qg) and pulled the original OxyContin from the market. The FDA determined that because the reformulated OxyContin has abuse-deterrent properties the withdrawal of the original OxyContin from the market was for safety reasons and therefore no generics of the original version will be approved.  The FDA stated:

                “The development of abuse-deterrent opioid analgesics is a public health priority for the FDA,” said Douglas Throckmorton, M.D., deputy director for regulatory programs in the FDA’s Center for Drug Evaluation and Research. “While both original and reformulated OxyContin are subject to abuse and misuse, the FDA has determined that reformulated OxyContin can be expected to make abuse by injection difficult and expected to reduce abuse by snorting compared to original OxyContin.”

While Perdue was in the unique situation of being the owner of the branded OxyContin and being able to withdrawal it from the market once their reformulation was approved - we believe this press release and action clearly explain the FDA's focus on switching the market to abuse-deterrent formulations.

In contrast, the FDA deemed ENDP's Opana ER to be insufficiently superior to Opana for tamper resistant properties, and therefore generics were allowed onto the market (http://tinyurl.com/kxw8wpr). It is important to note that the FDA did not grant Opana ER a differentiated label from Opana on the "abuse potential" subsection of the "Warnings and Precautions" section of the label.  We are in agreement with the FDA's conclusion that Opana ER was not able to sufficiently demonstrate superior abuse-deterrent characteristics over Opana, and continue to believe  that if MNK is able to appropriately demonstrate abuse-deterrent characteristics for their products that the FDA will grant them the appropriate labeling.  While the FDA would be cautious in deciding to withdrawal generic Percocet or generic Vicodin from the market after the approval of an abuse-deterrent formulation, we believe having an FDA approved label stating the abuse-deterrent benefits will yield significant market share for these products.  To put the potential upside to MNK in perspective, generic Percocet and generic Vicodin compete in the $1.6 billion short acting moderate pain market.

Could Roxicodone Become a Billion Dollar Product?

We believe that the little appreciated acquisition of Roxicodone could turn out to be a transformative acquisition for MNK if correctly executed.  In August 2012 MNK acquired Roxicodone from Xanodyne for undisclosed terms (http://tinyurl.com/kqh8h8g).  Xanodyne has been winding down its business as you can see from the chart below and the following article (http://tinyurl.com/kcx6tyc). 

This was an odd acquisition for MNK as they already produced a generic version of this product.  However, we hypothesize that MNK sees an opportunity to potentially convert the generic short acting oxycodone market into a branded one with the introduction of a tamper-resistant Roxicodone.  Generic oxycodone products currently sell $500M annually according to IMS – which would translate into a multi-billion dollar market in branded prices for a tamper-resistant Roxicodone. 

There are 3 branded versions of oxycodone (the active pharmaceutical ingredient) - OxyContin, Roxicodone and Oxecta.  Oxecta and OxyContin have no generic equivalents, only Roxicodone has generic versions available. 

Generics Approved for Roxicodone

 Source: FDA website

In November MNK increased the price, and then in July 2013 they doubled the price of the product.   

Pricing for Roxicodone

Source: Price Rx

A sustained version of Roxicodone was blocked from entering the market after Purdue won a patent lawsuit against Boehringer Ingelhiem. 

Roxicodone was approved when no other immediate release oxycodone was available.  Oxycodone did exist in the marketplace in other forms such as in combination with aspirin (Percodan), oxycodone combined with acetaminophen (based on similarity to Percodan) and Oxycontin (the original oxycodone controlled release formulation). 

We believe it is likely MNK has started development of a tamper resistant Roxicodone.  MNK already marketed a generic version of Roxicodone prior to their purchase of the branded product from Xanodyne.  We believe that MNK views ownership of the branded product as an opportunity to transform this generic market into a branded market with the successful development of a tamper resistant version.  In the meantime they have raised the price of the branded product to capitalize on the price inelasticity. 

Generic oxycodone is a very large market with 16 million scripts per year and ~$500MM in sales.  We believe that if MNK obtains an abuse resistant label they will garner substantial market share.  In the scenario that the FDA is willing to remove existing generics off the market with the approval of an abuse resistant label, this could become a multi-billion dollar market overnight.  While we think the FDA could have reservations in removing generics from the market unless the abuse-deterrent data were extremely compelling, given the recent OxyContin example we believe it is a real possibility. 

Source: IMS

Global Medical Imaging

MNK’s global medical imaging segment sells contrast media and delivery systems used in computed tomography (“CT”) and magnetic resonance imaging (“MRI”), as well as nuclear imaging agents.  Global medical imaging has a sales presence in approximately 50 countries worldwide and its sales mix is more globally diversified compared with specialty pharmaceuticals.  Global medical imaging generates approximately 50% of company revenues and is a stable business, generating cash that can be reinvested into the specialty pharmaceuticals business. 

Source: SEC filings

Contrast imaging is largely a commoditized market, with price pressures due to the extensive usage of group purchasing organizations (GPOs) by hospitals and physicians.  Significant products in the CMDS product portfolio include:

Source: SEC filings

Nuclear imaging is a more profitable segment due to the limited competition and difficulties in sourcing raw materials.  For instance, MNK is one of only 2 producers of Tc-99m generators in the US, one of only 3 in Europe and the only one in either continent that has its own Mo-99 processing facility, which provides cost and raw material supply advantages.

In late November 2012, the Dutch High Flux Reactor (HRF) experienced an unexpected shutdown affecting the supply of Mo-99 (http://tinyurl.com/k9zljvq).  This resulted in MNK having to procure supply from alternative sources at a higher than normal cost.  On June 11^th, 2013 the HRF was fully operational again (http://tinyurl.com/l5w6lut).  Thus we believe that margins will begin to normalize for MNK towards the end of the June quarter, with the full benefit seen in the September quarter. 

MNK does not break out the GM by segment therefore it is difficult to discern the exact impact of the higher procurement costs for the nuclear imaging business.  However, they do report operating income by segment.  Operating income dropped from 49.1M to 18.9M from the FY1Q13 to FY2Q13.

Their Form 10 filing states:

Global Medical Imaging. Operating income for the first six months of fiscal 2013 decreased $43.4 million to $68.0 million, compared with $111.4 million for the first six months of fiscal 2012. Our operating margin decreased to 14.8% for the first six months of fiscal 2013, compared with 22.0% for the first six months of fiscal 2012. The decrease in operating income was attributable to lower net sales discussed above and increased manufacturing and raw material costs, partially offset by a decrease in selling, general and administrative expenses. Our operating margin was most significantly impacted by higher raw material costs from the unscheduled shutdown of a nuclear reactor that supplies us with Mo-99. We expect operating income for our Global Medical Imaging segment to decline in fiscal 2013, compared to fiscal 2012, due to negative market trends, including a decrease in the number of procedures performed in developed markets and pricing pressure. In addition, we may continue to experience increased raw materials costs, partially as a result of the unscheduled shutdown of one of the reactors that supplies us with Mo-99, as discussed under “—Nuclear Imaging.”

We believe the $30MM hit in operating income quarter over quarter can be largely attributed to the increased procurement costs for nuclear imaging due to the shutdown of the HRF.  Though the December quarter had 1 month of higher raw material costs, the operating margin was similar to previous years.  It was the March quarter which had an operating margin of 8.2%, significantly lower than historical.  Nuclear imaging did $111MM in sales in the FY2Q13, a $30MM increase in COGS due to higher procurement costs, would equate to ~27% increase in COGS. 

Below we present our modeled COGS for the Global Medical Imaging business.  We see that COGS jump ~5 percentage points in FY2013 over FY2012 due to the disruption in Mo-99 supply, but this is expected to normalize in the FY4Q13 and over FY2014. 

COGS for the Medical Imaging Business

Overall COGS for MNK were less affected in FY2013 due to the offsetting impact of the higher GM specialty pharmaceutical products such as generic Concerta.

Gross profit. Gross profit for the first six months of fiscal 2013 increased $18.7 million, or 3.8%, to $507.0 million, compared with $488.3 million in the first six months of fiscal 2012. Gross margin was 46.5% in the first six months of fiscal 2013, compared with 47.6% in the first six months of fiscal 2012. The increase in gross profit was primarily the result of higher net sales in the first six months of fiscal 2013 and favorable product mix resulting from increased sales of our higher margin pharmaceutical products. These factors were partially offset by increased manufacturing costs and increased raw material costs, primarily attributable to the unscheduled shutdown of a nuclear reactor that supplies us with Mo-99. The increase in raw material costs also resulted in a decrease in gross margin in the first six months of fiscal 2013.

We believe that FY2014 gross profit for the medical imaging segment will be $45MM higher than FY2013 due to the resolution of the raw material disruptions.

The global medical imaging business has no natural comps. While this lack of comps makes valuation more difficult, it also highlights the high barriers to entry and limited competition for this business.

Management Compensation

Management was issued new MNK stock options on July 1st, 2013 with a strike price of $44 a share.  Prior to the spin off, management had an incentive to be quiet about the business to ensure the lowest possible strike price on their MNK stock options.

Initial Equity Grants

On July 1, 2013, the Compensation and Human Resources Committee of the Board approved grants of initial equity awards to certain of Mallinckrodt’s executives, including the following grants to the named executive officers of Mallinckrodt:

Each restricted stock unit award (except for Mr. Trudeau’s restricted stock unit award) and stock option award will vest in two equal amounts on each of July 1, 2016 and 2017. The stock option awards have an exercise price of $44.00 per share and a 10-year term. Mr. Trudeau’s restricted stock unit award vests in its entirety on July 1, 2018.

The restricted stock unit awards and stock option awards were made pursuant to the terms and conditions of the Mallinckrodt Pharmaceuticals Stock and Incentive Plan that became effective on July 1, 2013, a description of which is included under the section “Executive Compensation” in the Information Statement, which is incorporated by reference herein, and pursuant to the terms and conditions of the applicable award agreements, the forms of which are filed as Exhibits 10.8, 10.9 and 10.10 to this Current Report on Form 8-K and incorporated by reference herein.

Source: SEC Filings

Now that the options have been issued, the company is likely to be more forthcoming on its  business strategy to the Street – for example hosting an analyst day which most spin off companies do before they spin not after. We believe that the analyst day later in 2013 could be a positive event.  For instance the 5 ANDAs in MNK's pipeline could be highlighted and probabilities of success could be increased.  While we know that these generics will enter categories where generics already exist, clarity around the specific indications would allow increased visibility over the next few years. 

Under-levered Balance Sheet Allows Room for Acquistions

MNK is only being spun off with $900MM in debt.  We estimate that MNK will generate $395M of EBITDA in 2014, giving it substantial room to increase its leverage. If MNK were willing to take debt up to 5x EBITDA, it would have over $1 billion of capacity for acquisitions or share repurchases. While the EBITDA could fluctuate year to year due to the impact of additional competition in Concerta and Exalgo, the underlying imaging business and API business is very stable.  With 200 sales people promoting their pain products now, and a planned expansion to 500 in the near future, we believe there is additional leverage in their business model from targeted bolt on acquisitions like the company’s purchase of CNS Therapeutics in 2012.

The Irish Tax Structure is Attractive to Potential Acquirers

There have been a number of acquisitions of companies domiciled in Ireland to take advantage of the lower Irish tax rate - the recent WCRX acquisition by ACT for example where the principal rationale for the merger was to reduce ACT’s corporate tax rate.  ELN, another Irish company also has been the subject of takeout interest.  JAZZ Pharmaceuticals acquisition of Irish-based Azur pharmaceuticals and ALKS’s acquisition of Elan Drug Technologies were likely also based in part on acquiring a lower taxed Irish subsidiary where future IP could be domiciled.  The basic corporate tax rate in Ireland is 12.5%, but many Irish companies have tax rates below this. 

MNK guided to a tax rate of 34-38% for 2013. We think this is way too high and not representative of the go forward tax rate of the company. We expect MNK’s corporate tax rate to come down significantly more towards other Irish domiciled peers around 10-15%. This is another lever for EPS and free cash flow growth going forward. MNK has to date not guided the street towards its long term tax rate, another data point we would expect the company to provide at its upcoming analyst day.

Acquisitions Continue to be a Strong Theme in Specialty Pharma

It is interesting to note that there are very few specialty pharmaceutical companies in MNK's market cap range; only IPXL, SGNT and ENDP have market caps lower than $5B. Over the last few years, most of specialty pharmaceutical companies of MNK’s size have been acquired.  PFE’s acquisition of King Pharmaceuticals for $3.3B and VRX’s purchase of BVF for $3.7B are examples of the consolidation in this space. We believe that acquisitions in the space will continue to be a theme going forward and that MNK will be a prime candidate as it is small enough to be easily digestible, yet still large enough to make a financial impact for many potential acquirers. 

MNK generates significant free cash flow

MNK has guided to capital expenditures of $140-160M in FY2013, of which $20M are one-time expenses to build out the corporate infrastructure and information technology systems.   At the midpoint of their guidance would yield capital expenditures as 6.8% of sales.  As the table of peers below shows, this is far higher than what other specialty pharmaceutical companies are spending and we believe that this will come down over time. 

Valuation

On an EV/EBITDA basis MNK trades at a substantial discount to the peer group.  The mean EV/EBITDA of the specialty pharma group is 12.8x and 11.8x in 2014 and 2015.  In comparison MNK trades at 8.8x and 8.6x our EBITDA estimates, among the lowest in the comp group. 

Similarly, MNK trades at the lowest multiple of EV/Sales in the group, and at about half the mean for the comp group.  We understand that half the sales come from the imaging business which is difficult to find a comp for, but trading at ~1.5x EV/Sales would imply zero value for the imaging business which is highly stable and cash generative if we assume the specialty pharma business trades at a multiple similar to peers.

At a 12x multiple of 2014 EBITDA, in line with the comp group, MNK would be worth $69 per share in twelve months when taking into account their FCF accumulation. MNK’s value will be further enhanced in future years as they gain approval and launch MNK-795 and MNK-155 which are really F2016 revenue and EBITDA contributors. Our estimates do not assume any great success from Roxicodone which could be another lever for significant EBITDA and therefore valuation upside.

Appendix A: Financial Model

We model a slight decline in adjusted EBITDA in FY2014 and FY2015.  This is due to a 50M increase in SG&A in 2014 due to expected expansion of the sales force from the 200 today to ~500. 

Appendix B: Most Healthcare Spin-offs Perform Well

Healthcare spin-offs have done very well over time.  The latest spin-off of ABBV is a case in point.  Bank of America recently published a report on healthcare spin offs since 2000 and found that of the 17 companies that have been spun out, the average appreciation is 200% from spin until the present.