When Should Investors Buy This New Pharma Company?

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After nearly two years of waiting, Covidien (NYSE: COV) investors were finally treated to the latest in a long line of pharmaceutical and medical device spin-offs. As of July 1, 2013, Dublin-based Covidien and St. Louis-based Mallinckrodt Pharmaceuticals (NYSE: MNK) had formally split into separate companies that traded independently of one another. Although the companies have thus far experienced divergent share-price performance, this development has been welcomed by investors on both sides of the split.

Going forward, investors who have any interest in the medical device business or pharmaceutical industry will have plenty to digest. Since recent spin-offs from companies like Abbott Labs (ABT) and Pfizer (PFE) have met with success and critical acclaim, the Mallinckrodt-Covidien split will not be judged in a vacuum. However, investors should be cautious about drawing direct parallels between this situation and previous spin-offs. It would be far more useful to mount a reasoned value analysis of the two firms and determine how they stack up to one another and to their principal competitors.

Mallinckrodt: Undervalued Relative to the Competition?

Covidien and Mallinckrodt have pursued this split with some clear goals in mind. Most importantly, the two firms have naturally divergent areas of operation: Whereas Covidien primarily produces surgical devices and medical supplies, Mallinckrodt concentrates on generic drugs and diagnostic equipment. Many market-watchers and industry insiders have long suspected that Covidien's shareholders and employees would be better served by a formalization of this split. 

Although Becton, Dickinson and Company (NYSE: BDX) has more in common with Covidien, it competes directly with both firms. Since Mallinckrodt is such a new firm, it has not yet released formal financial statements that could provide a comprehensive window into its valuation and performance. However, its market capitalization currently sits at around $2 billion. Its revenues come in at just below this figure. By contrast, Covidien sports a market cap of just over $27 billion and gross 2012 revenues of $12.2 billion. Becton's market cap hovers around $20 billion and complements 2012 revenues of $7.9 billion. 

Whereas Mallinckrodt has a somewhat depressed price-to-sales ratio of 1.2 and a P/E ratio in the neighborhood of 15, Covidien sports a price-to-sales rating of 2.25 and a P/E ratio of about 15. Becton boasts an elevated price-to-sales figure of nearly 2.5 and a P/E of 16. Mallinckrodt also scores relatively low on another common valuation method: the ratio between its current enterprise value and its most recent EBITDA figure. By this metric, Mallinckrodt is significantly undervalued: Its EV-to-EBITDA ratio comes in at around 8.2. Covidien's ratio hovers on either side of the double-digit mark, and Becton's comes in at nearly 11. Assuming that all other things remain equal, this suggests that Mallinckrodt is undervalued by at least 25 percent relative to its peers. 

How the Spin-off Happened

Mallinckrodt's spin-off occurred on June 28, 2013 and was consummated on the first trading day of July. On that date, Covidien shareholders received one share of Mallinckrodt for every eight shares of Covidien that they had held on the transaction's record date. Market-watchers pinned the value of this transaction at just over $2 billion. 

Past and Future Price Performance

Mallinckrodt's initial trading period was rough on its new shareholders. From an initial trading price near $45 per share, the company's shares have fallen by nearly 6 percent to close below $43 per share. Since this movement occurred in a rising market, it suggests that Mallinckrodt's investors were skeptical of the company's outlook and wished to profit from the windfall that they received in the transaction. Since shares often fall in the aftermath of well-capitalized spin-offs, this movement does not necessarily bode poorly for Mallinckrodt's long-term outlook.

Indeed, even some of Covidien's most faithful long-side investors believe that the spun-off pharmaceutical concern offers a better value than its former parent. The firm's diagnostic imaging division represented Covidien's fastest-growing and most lucrative arm, and its generic-drug business was a reliable source of income in an era of rising R&D costs. This has led many seasoned market veterans to conclude that Mallinckrodt is seriously undervalued at its current levels.

Long-Term Outlook and Investment Thesis

This is an attractive thesis. Mallinckrodt's solid fundamentals and promising growth prospects endear it to value-minded investors, and its potentially revolutionary imaging business adds a bit of speculative flair to the mix. By nearly every valuation metric, the company compares favorably to its peers. At the same time, it has exhibited financial performance that meets or exceeds the standards of the broader medical device and pharmaceutical industries.

Of course, Mallinckrodt has a few weaknesses that could impact its growth prospects and relative performance. The company probably lacks the capacity to produce a blockbuster device or process within the next several years. Accordingly, it will have to rely on income and growth from legacy operations, including its generic drug business. Unfortunately, generic drug segments can be vulnerable to cost pressures and competition. As such, prospective investors must perform careful due diligence before taking a long position in Mallinckrodt. Given its negative price momentum, patient investors may wish to wait for an even more attractive entry point.

Mike Thiessen has no position in any stocks mentioned. The Motley Fool recommends Becton Dickinson, Covidien, and Mallinckrodt plc. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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