Mallinckrodt (MNK) was halted pre-market on Friday on a breaking news story. The Tax Cut and Jobs Act (“TCJA”) recently passed by Congress and President Trump is expected to result in a deferred tax benefit of $450 – $500 million:
Mallinckrodt (NYSE:MNK) says the GOP’s Tax Cut and Jobs Act will be neutral to modestly positive on its non-GAAP tax expense. If enacted, as expected, it will have a deferred tax benefit of $450M – 500M mainly associated with a reduction in its interest-bearing U.S. deferred tax liabilities ($1.6B as of the end of September) to reflect the reduction in its federal income tax to 21% from 35% effective January 1, 2018.
The beneficial impact of the lower tax rate will be mostly offset by tighter limitations on interest rate expense deductions.
MNK actually fell 1% Friday on the news. Below I will parse through the implications of the deferred tax impact.
Deferred Tax Benefits Could Marginally Boost Equity
The deferred tax benefit is a positive for Mallinckrodt. The company has engaged in several acquisitions and divestitures in recent years, leading to an inefficient legal structure. Mallinckrodt has maneuvered to simplify its legal structure, resulting in a one-time tax expense of $36 million. Management also announced an expected one-time tax benefit in excess of $800 million:
As these changes have now been completed in the fourth quarter, we expect to see a one-time tax benefit in excess of $800 million to be recorded in our annual financial statements, with a corresponding decrease to our deferred income tax liabilities by the same amount.
Mallinckrodt announced the benefit in conjunction with Q3 earnings. My impression was that Management was attempting to change the narrative from disappointing top line growth to the positive impact the tax benefit would have on the balance sheet. However, it did not work. The company’s total revenue was off 11% Y/Y. Revenue from its blockbuster drug Acthar was down 6%. The drug represents 39% of total revenue and has been the company’s one remaining catalyst. MNK cratered 30% on the news.
Managment’s current estimate that the Republican tax cut will result in a $450 – $500 million benefit appears positive on the surface. How this impacts the previous $800 million figure management previously quoted remains to be seen. This is important. The diminution in Acthar could cause investors to question the going concern value of Mallinckrodt and put more emphasis on the balance sheet.
At Q3 2017 Mallinckrodt had equity of $5.1 billion, goodwill and intangibles of $12.0 billion and tangible GAAP book value of -6.9 billion. A $500 million deferred tax benefit could increase the company’s tangible GAAP book value to -$6.4 billion. Mallinckrodt’s enterprise value would have to exceed $6.4 billion or else the company’s total GAAP book value could be deemed as less than $0. Currently its enterprise value (including net debt of $5.5 billion) is around $7.7 billion.
Market chatter suggests Acthar’s use for indications other than infantile spasms could be in decline. Express Scripts (ESRX), a keep distributor, might also be cutting back on Acthar prescriptions. This intimates that the drug’s revenue could fall further. Management cut R&D costs and SG&A by 23% and 12%, respectively. This offset the double-digit decline in revenue. As a result EBITDA only fell by 8% Y/Y. I expect earnings to continue to slide amid a diminution in top line growth. Can management continue to cut R&D and SG&A expenses to mute further erosion in its top line? In turn, the credit metrics for Mallinckrodt’s $5.8 billion debt load and its going concern value could become causes for concern.
Interest-Bearing Deferred Tax Liabilities To Decline
At Q3 Mallinckrodt had deferred tax liabilities of $2.3 billion. Much has been written about the $1.8 billion of interest-bearing deferred tax liabilities:
During the three months ended March 31, 2017, the Company sold its Intrathecal Therapy business with a portion of the consideration from the sale being in the form of a note receivable subject to the installment sale provisions described above. As of June 30, 2017, the Company had an aggregate $1,781.7 million of interest-bearing U.S. deferred tax liabilities associated with outstanding installment notes … The Company recognized interest expense associated with the Section 453A deferred tax liabilities of $17.8 million and $18.6 million for the three months ended June 30, 2017 and June 24, 2016, respectively.
Management now expects the TCJA to reduce its interest-bearing deferred tax liabilities to $600 million:
The reduction in the interest-bearing deferred tax liabilities expected from the enactment of the TCJA is in addition to the expected reduction reported as a subsequent event in the Quarterly Report on Form 10-Q for the period ended September 29, 2017. The Company now expects its interest-bearing deferred tax liabilities to be less than $600 million after both events are reported, and will continue to look for opportunities to offset this liability with tax attributes in addition to interest expense deductions within the limitations described above.
Mallinckrodt pays quarterly interest expense of about $93 million. That should decline going forward. Its quarterly EBITDA of $336 million equates to interest coverage of about 3.6x. Going forward the stock price could be driven by the company’s ability to service its debt and remain solvent. A reduction in interest-bearing liabilities by over $1 billion is a positive event.
Conclusion
Rising assets and declining interest-bearing liabilities are positives for Mallinckrodt. However, the diminution in Acthar is concerning. Not only is the drug overpriced but it also appears oversubscribed. As Acthar goes so goes MNK. Avoid the stock.
On Trump And The Global Economy
Trump And The Global Economy Town Hall took place October 24th in Fort Greene. It Featured Professor Lance Brofman, Coconut Rob (Coconut Rob Smoothies), Wuyi Jacobs (AfroBeats Radio) and Ralph Baker, author of Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead.
The event was well-received by the community. We parsed through President Trump’s proposed tax plan and [i] how it was pure economic folly and [ii] high net worth individuals could potentially game the system by shifting income around. Apparently, Kansas Coach Bill Self did this when the state of Kansas cut taxes in the past. We discussed the pros and cons of technology on workers and the economy. How will the economy and country prosper under Trump’s leadership vis-a-vis Obama? What’s behind the verbal sparring with black athletes, ESPN’s Jemele Hill and North Korea’s Kim Jong Un?
