Purchase #7: Mayne Pharma Group Ltd

Purchase #7: Mayne Pharma Group Ltd

I’ve made another purchase for the 10foot portfolio, generic pharmaceutical company Mayne Pharma Group Ltd (ASX: MYX). Mayne manufactures and sells generics, consults for third parties,  sells its own specialty branded drugs, and develops new formulations for existing molecules. Mayne Pharma recently had a huge step-change in its operations after the $900m acquisition of a portfolio of drugs from Teva and Allergan that more than doubled the company’s market capitalisation.

This is the longest Purchase piece I’ve written so far and it doesn’t cover half of what I’d like to. I’m going to dive straight in but I’d suggest just reading ‘the Thesis’ section and then skipping ahead to ‘when I would sell’ and reading from there. I also have an abbreviated version which you can read instead. 

Here’s where the sales come from:

Here are the segments by their contribution to gross profit:

Generics (blue) are by far the main driver, although Specialty Brands (grey) is also surprisingly important because this business achieves a 95% gross profit margin (!) so modest changes in revenue can have a big flow-through effect on profits.

Mayne has undergone a huge step-change with a massive capital raising to acquire the Teva portfolio last year. Shares have since been sold off heavily (down 65% YTD) after the company announced changes to its Teva/Allergan portfolio, shortening drug lives from 20 years to 15 years, and declared that price competition had hurt sales. I’ll get to that later in the risks section. Here are some quick stats on Mayne:

• Market cap: $974 million (1.433bn shares @ $0.68 purchase price)
• Enterprise value: $1,251m
• EV/EBITDA of 6.07x
• P/E of 11x
• Net debt $274 million
• Leverage ratio of 1.7x (vs covenant <2.75x) interest cover of 28x (covenant <3x), plenty of headroom on debt

 

The thesis: 

Part 1: Mayne is currently undervalued. Investors are spooked by the possibility of more cockroaches in the Teva/Allergan kitchen and have sold the company down to levels that don’t represent its earnings potential. Once capital expenditure on manufacturing facility finishes and working capital build from FY17 starts getting turned into cash, Mayne should prove good value in terms of today’s price vs its cash generating ability.

Part 2: In addition to that, Mayne has good prospects of growing. I think the company could reasonably achieve +5%-10% revenue growth p.a. over the next 2-3 years from its drug portfolios and contracted services. On top of that there are additional benefits to come from Teva integration (cutting costs and bringing Teva manufacturing in-house in FY19). Growth is not guaranteed, but a few pieces are coming into place and I think there’s a good chance that some will occur.

If Mayne can generate anything like the kind of cash I think it can (say, $150m+ ish FCF excluding investment in growth) and grow revenues at historical profit margins, it could be a nice winner. On the flip side of course, Mayne could turn out to be a melting icecube. A key risk is that the company just keeps chasing acquisitions and never consistently generates cash flows that would justify a higher price.

The thesis is pretty straightforward. The risks are where it gets thorny. There are 4 primary concerns:

1. Market share (typically I would expect market share to decline over time as more generic competitors enter)
2. Drug price (in addition to market share and competition, insurers or regulators etc could force lower prices in a variety of ways)
3. Obsolescence (Mayne deems this a low risk, but therapeutic replacement and/or a switch to alternative therapies still a possibility. Plus, generic revenues are expected to decline over time without reinvestment)
4. Low returns on investment. ROE is not all that good given the type of growth Mayne has been talking about in recent years.

 

The risks:

Since the company is so dependent on a) its generic products division and b) recently acquired Teva/Allergan drugs, I took a closer look at these areas. In particular I wanted to see if the Teva/Allergan drug portfolio was a dog, and I don’t think that it is.

Using these links from the US Federal Trade Commission:

Teva/Allergan divested drugs

Teva/Allergan consolidation concerns

The story is that Teva is acquiring another large generic manufacturer, Allergan. Teva was forced to divest a bunch of drugs before the Allergan takeover could go ahead, otherwise Teva would have acquired too much market power in certain drugs (see second link above). Mayne may have been screwed on the price for these drugs (given the recent downgrade; i.e., it overpaid), but I do not think it was screwed on the market share of these drugs. A regulator (FTC) forced Teva to divest these drugs in order to maintain competition in the marketplace, which is a bit different to the average divestment (could be better or worse). So Mayne maynetains (heh) at least some competitive position in my opinion.

I did a brief list of Teva’s drugs vs the FTC’s consolidation concerns.  At a glance it looks as though approximately 1/4 of the acquired drugs were potential 2 to 1 consolidations (I.e., when Teva and Allergan combine, they would have gone from 2 manufacturers – Teva and Allergan – to one manufacturer, TevAllergan). The remainder of the drugs and the future pipeline drugs were a majority 4-3 and 3-2 consolidations.

So?

Being the single or one of only two resellers of a drug in the market is great because typically I would expect higher margins and market share. However, over time, you can expect to lose more market share as more generic competitors come in (the ice cube melts faster; depends on exclusivity periods etc). Mayne has rapidly captured market share in the past when it has entered a market with a generic. So the 2-1 consolidations for example are probably more valuable, but they are more likely to lose market share/value faster over time. With most of the drugs having multiple other generic competitors I felt that the likelihood of Mayne losing huge value quickly here is unlikely. Company research shows that drug price declines typically flatline after ~2 years, there also isn’t a huge ‘race to the bottom’ on price like might be expected in other manufacturing businesses.

(A side note, I think it would be possible for a dedicated analyst to get an informational advantage by tracking every single drug that Mayne owns and see when generic competitors are about to enter the market, via FTC filings and announcements. I did have a brief crack at that but it very quickly got too time-consuming.)

Following that line of thought, this is Mayne’s (post-Teva) generics product breakdown by number of competitors:

Although a significant amount of revenue is at risk from greater generic competition, approximately half of the company’s revenues appear relatively stable at least in terms of market share. Pricing is a risk although with several competitors for most of Mayne’s drugs already, I believe current profitability is relatively maintainable, outside of regulatory intervention or crazy competition.

I give regulatory intervention a low likelihood because Trump and big pharma gravy train with lobbyists etc. Only a small percentage of Mayne’s sales come from opiates too, so downside there appears limited (given the ongoing prescription drug abuse in the USA).

I also give heavy price competition in pharma a low likelihood because high margins are the whole industry’s lifeblood. It is a risk but I believe through research that the large players are not incentivised to compete on price at all. This lack of active competition appears to be the foundation of the recent accusations of price-fixing in the US generics industry. The NZ competition commission has written a few times about ‘soft collusion’ where companies don’t need to confer to create unnaturally high prices; all they need to do is mimic each other.

I couldn’t say for sure whether that’s the case in the USA, and I’m not suggesting Mayne Pharma is doing anything illegal. Potential price fixing/ price regulation is a huge risk though, so if you disagree, i’d like to hear from you. Having said that, and being passably familiar with the US pharmaceutical industry, on balance I also think that it is highly likely that there are pockets of soft price collusion going on, I just wouldn’t know who or how or where. The entire industry is like a swamp of alligators.  So while being aware of the risk, I am also currently trusting management’s statements when they say that there is no significant risk to revenues from regulation.

The specialty brands division

Mayne uses R&D to develop new products for its specialty brands division. Most of these are either new formulations (e.g. converting a tablet into a topical foam for eg) or new versions (e.g. 50mg down from 120mg) of drugs. Although it’s a small-ish contributor to profit (19% of gross profit), Specialty Brands earns sickeningly high gross profit margins of 95%. It would take very little growth here to move the dial for Mayne, and the company has recently doubled its sales team in order to push the rollout of its drugs, especially Sorilux and Fabior. On the downside, it doesn’t take a lot of imagination to see this division moving against the company either, especially with the recent introduction of a generic version of Doryx (doxycycline hyclate) from both Mayne and a competitor.

More than any other division, the Specialty Brands division could be, in my opinion, the classic melting ice cube.  Revenues plunged because Mylan launched a generic doxycycline, and Mayne also launched one. Both generics are competing with Mayne’s branded Doryx, and obviously if you are a smart consumer, you would rather buy the version with a 50% gross margin (i.e., smaller markup) than the one with a 95% gross margin. However, insofar as sales of Doryx et al can be maintained through marketing and promotions/ trust in brand name/ specified prescriptions from doctors etc, they represent a hugely profitable business even if sales continue to decline. Management also doubled the sales team here and is focusing more heavily on Sorilux and Fabior this year in addition to Doryx.

On balance, with new products (a delayed-release Doryx among others) and a beefed up sales team, I think the decline here should not be overly concerning. The generic Doryx was released in 1Q16 so biggest impact is probably already realised, and there is a fair possibility of sales growth.

The serial acquirer

It’s hard to determine exactly how much value has been added over the past few years, because Mayne has had a major acquisition every 2nd year since 2013, which clouds the results, plus drugs are generally ‘depreciating assets’ (because of risk of replacement/competition etc) so it is quite hard to judge. However, some acquisitions such as Doryx and Metric Contract Services (MCS) have clearly become significant contributors to earnings. On balance I believe that management has acquired smartly in the past, which is why I’m more comfortable than the Teva acquisition than I would otherwise be.

(Heuristic: Buying a business larger than your own and then merging the two often ends in tears)

I would be looking to see minimal acquisitions in the near future however, as well as a return to previously high levels of return on equity. Otherwise it will look as though the company is acquiring its way into mediocrity.

The other main issue is that it may be hard for this company to get revalued. Mayne profits in the past have been lumpy and the share price has not followed the profits particularly well. It’s not hard to foresee a strong FY18 with no SP change, followed by FY19 which is clouded by another acquisition while I sit here and twiddle my thumbs. I’m not buying with a two-year timeframe in mind, but it is hard to make an accurate forecast past that point, especially in this type of business, and with a history of growth by acquisition. So a big issue here is that I don’t have a view of what 2+ years in the future looks like – I have to trust the company (and management’s) process.

If Mayne is a cash machine there would either need to be really smart reinvestment of cash that clearly creates value, or an intent to return it to shareholders somehow, and i do not think the latter is likely.  So those are my uncertainties.

Lastly, focusing on cash flow (ignoring D+A) is less useful here than at some other businesses. This is because most of Mayne’s assets are intangibles and thus amortisation reflects a very real decline in the likely future value of those assets (brands etc). Sure I get the cash flow now but it does need to be shrewdly reinvested to offset the decline over time.  I have run out of space to discuss management, but in general I thought they are reasonably experienced and aligned, and I trust their ability to reinvest.

When I would sell: 

Three main situations:  A) If Mayne turns out to be a severely melting icecube (bearing in mind that some market share loss is part and parcel of the business) either through market share loss or strong pricing pressure. b) If previously undisclosed misbehaviour gets the company blown up. And c) if acquisitions don’t create value and Mayne still keeps trying to acquire stuff.

The bottom line: 

The overwhelming factor driving this investment is that Mayne needs to prove it can generate the cash and profits to deliver an adequate return on its Teva acquisition. Either it will and it will live up to my expectations, or it won’t and there will probably not be a happy outcome. Debt is survivable and I have alleviated my Teva and regulatory concerns through research.

Still I think Mayne is the type of company where there could very easily be tail risks lurking in the regulatory and competitive environment. If you have a strong view on ‘I would avoid this company at all costs’, I really want to hear from you.

I also think Mayne is the type of company where a detailed brokerage report would come in really handy, just to quantify some more of the knowables. If you happen to have one handy and would like to accidentally drop it in my electronic mailbox 10footinvestor@gmail.com, I would be deeply appreciative.

On 30/08/2017 I bought 800 Mayne Pharma shares at $0.6625 plus brokerage, for $544.95, or $0.6811 apiece.

Unrelated footnote:

It took me about 5 minutes to write this thesis and 3 hours to list the risks. I have it on good authority that that’s the way it’s supposed to be, but gee whiz when you spend three hours writing about how your company is going to blow up, you get to the end and go ‘my god, what have I done?!’

Second unrelated footnote:

I recently read an interesting article that implies shorter analyst reports (~10% shorter than average) achieved significantly better results. This was attributed to not becoming so familiar with a business that you automatically love it, but I also think that a more precise focus on the important things is a major contributor. So I’m going to try keeping my next Purchase thesis very short <1000 words and see how that goes for me. Stay tuned.

I own shares in Mayne Pharma Group. This is a disclosure and not a recommendation.