Mayne Pharma bitten by competition

When we recommended you avoid Mayne Pharma 18 months ago, we warned: 'Our main concern is with how management is incentivised - what that has meant for shareholders in the past, and what it could mean for shareholders in the future'.

Specifically, management was (and is) incentivised to grow overall earnings rather than earnings per share. As such, we were worried the company might overpay for drug acquisitions in the name of earnings growth and dilute shareholders with capital raisings to fund it. 

It was little surprise then to hear this from management in this week's profit warning:

'Given the prevailing US generic market conditions and outlook, the Company will be performing a detailed review of the carrying value of its [intangible assets]. Any impairment would reset the balance sheet, improve reported profit in future periods and is consistent with many US generic peers who have also made impairments of their generic intangible assets over the last few years.' 

If that sounds positive to you, management hit the intended tone. Unfortunately, it's bullshit. 

The notion that a company can improve profits by writing off the value of its assets is true in an accounting sense. Mayne capitalises around 80% of its research and development spending, which creates an intangible asset on the balance sheet. Acquired drug licences are also counted as an intangible asset. These intangibles are then amortised as an expense over 10 to 15 years and reduce profits. 

By writing down the value of its intangible assets, those amortisation charges disappear and profits go up. Make no mistake, though: that's a really bad way to grow profits. All it says is that the company overpaid for something in the past - and that it's simply bringing forward all the recognition of that fact. The cash went out the door years ago; the balance sheet is only now playing catch up.  

Rising competition

Mayne sells generic drugs - those that have been around a while but that are no longer covered by patents.

Management said that total revenue was $154m in the first four months of the year, a decline of 15% compared to last year. Gross profit fell 20% to $79m. The main culprit was increasing competition in the US - where the company earns 90% of its revenue - especially for key products liothyronine and dofetilide

Given that most of Mayne's products aren't protected by patents, strong competition is inevitable because there are fewer barriers to entry. Anyone can make these medicines. 

Price declines are the norm - so much so that the market is shrinking in dollar terms, despite growing demand. Management said that competition has become so intense that only one-third of generic drugs approved by the FDA last year were actually launched; companies are holding back due to the poor pricing environment. 

Management expects the 2020 financial year to be better than 2019 due to the release of two new specialty drugs, Tolsura and Lexette. That might patch an earnings hole in the short term but, if US competition continues to rise, the long-term outlook is bleak. It's conceivable that US margins erode so much that Mayne won't turn a profit at all.

The stock trades on a price-earnings ratio of 14, but the underlying figure could be double that based on forecasts for 2019 earnings. With pricing pressure and a deteriorating balance sheet, we continue to recommend you give this stock a wide berth. The share price is down 25% since our Avoid recommendation, and we're CEASING COVERAGE.