The United States has an opioid epidemic and drug manufacturers like Mallincikrodt (MNK) are right in the middle of it. Last week Missouri Attorney General Josh Hawley expanded its opioid marketing investigation to seven companies, including Mallinckrodt:

Missouri Attorney General Josh Hawley continues to widen his investigation of opioid manufacturers, today announcing the issuance of civil investigative demands to seven major opioid manufacturers. These investigative demands require the manufacturers to provide documents and information relevant to the Attorney General Office’s ongoing investigation of the pharmaceutical industry’s marketing practices for opioids.

The office issued investigative demands to Allergan, Depomed, Insys, Mallinckrodt, Mylan, Pfizer, and Teva Pharmaceuticals.

“Our office is dedicated to stemming the tide of opioid abuse in Missouri,” Hawley said. “We hope that our continuing investigation will aid the fight to build a healthier Missouri and end this epidemic in our state.”

Pursuant to the current investigation AG Hawley is seeking documents related to the drug companies’ marketing practices and other industry organizations that helped them promote opioids.

America’s Opioid Crisis

Drug overdose the leading cause of accidental death in the U.S. According to the National Institute on Drug Abuse in 2015 the number of drug overdoses were 52,404, up from 23,518 in 2002 – a 6% compound annual growth rate (“CAGR). Of the 2015 figures prescription drug overdoses and opioid prescription drug overdoses as a total of all drug overdoses were 57% and 45%, respectively. In 2002 total overdoses of prescription drugs and overdoses of opioids as a percentage of total drug overdoses were 49% and 32%, respectively. Overdoses of opioids grew faster than total overdoses. Some experts believe the increase in opioid prescriptions could be driving the increase.

Overdoses from prescription opioids have coincided with the proliferation of opioid prescriptions. According to The Economist between 1991 and 2011 opioid prescriptions supplied by retail pharmacies increased from 76 million to 219 million – a 5.4% CAGR.

Attorney General Hawley believes than in certain cases drug makers fraudulently misrepresented the serious risks posed by opioids and how deadly and addictive prescription opioids could be. Such false advertising could have help create a drug epidemic in the state of Missouri. In June he filed lawsuits against Endo (ENDP), Janssen Pharmaceuticals and Purdue for misrepresenting risks posed by the opioids they manufactured.

Risks For Mallinckrodt

Mallinkrodt is known for Acthar, which treats infantile spasms and certain autoimmune conditions. Acthar’s revenue for the quarter-ended June 2017 was $319 million, up 7% Y/Y. It currently represents 39% of the company’s total sales which fell 5% Y/Y. Acthar’s strong performance has masked the underperformance of specialty generics which experienced a 17% revenue decline last quarter:

A closer look at specialty generics reveals revenue for opioids hydrocodone and oxycodone fell Y/Y by 40% and 18%, respectively. As state governments look to tamp down opioid prescriptions and use, sales of these drugs could fall further. The specialty generics segment represents 26% of total revenue; hydrocodone and oxycodone represent about 22% of specialty generics.

Opioid Investigations Could Sting

According to the company’s most recent quarterly report it is facing a lawsuit in Multnomah County Circuit Court in Oregon for the alleged creation of a public nuisance for the marketing, manufacturing and promotion of opioids. The plaintiff is seeking economic damages. In July 2017 it received a subpoena from the Department of Justice pursuant to its marketing of opioids. In June 2017 certain district attorneys general filed a lawsuit against Mallinckrodt in Kingsport, TN alleging violations of Tennessee’s Drug Dealer Liability Act and public nuisance laws pursuant to its marketing of opioid drugs.

In July Mallinckrodt agreed to pay a record $35 million settlement for failure to report suspicious orders of pharmaceuticals and for record keeping violations:

Mallinckrodt LLC, a pharmaceutical manufacturer and one of the largest manufacturers of generic oxycodone, agreed to pay $35 million to settle allegations that it violated certain provisions of the Controlled Substances Act (CSA) that are subject to civil penalties, Attorney General Jeff Sessions of the Justice Department and Acting Administrator Chuck Rosenberg of the Drug Enforcement Administration (DEA) announced today …

“In the midst of one of the worst drug abuse crises in American history, the Department of Justice has the responsibility to ensure that our drug laws are being enforced and to protect the American people,” said Attorney General Sessions. “Part of that mission is holding drug manufacturers accountable for their actions. Mallinckrodt’s actions and omissions formed a link in the chain of supply that resulted in millions of oxycodone pills being sold on the street …”

These actions could result in more financial settlements between Mallinckrodt and state lawmakers. Even if the lawsuits and/or investigations do not results in financial pay outs they could create distractions for Mallinckrodt’s management team and create extraordinary legal fees as the company defends itself against these allegations.

That said, the company does have ample liquidity and strong cash flow. Mallinckrodt currently has $330 million. Through the first six months of the current fiscal year it generated $121 million, representing a run-rate of about $242 million. Of its $5.9 billion debt load $519 million is listed as current maturities. This could crimp cash flow. The company also has a $900 million revolving credit facility it could potentially use to help meet obligations under its term loan.

However, Mallinckrodt cannot keep kicking the can down the road. While Acthar continues to carry the company, I estimate specialty generics generate over 20% of EBITDA. Total quarterly EBITDA of $333 million was off 9% sequentially and 13% Y/Y. It could fall further if opioid sales continue to crater. That said, Moody’s rates Mallinckrodt’s debt at Ba3 (junk levels) and expect its debt/EBITDA to remain at 4.0x for and extended period or risk being downgraded. Debt/run-rate EBITDA is currently around 4.4x, so the company must maintain cash flow to protect its balance sheet. Investigations and potential fines from stage AGs will not help matters.

Takeaway

Mallinckrodt’s dependence on Acthar sales is well-documented. Its exposure to declining sales and potential fines related to America’s opioid epidemic is not.