Mallinckrodt plc
Q3 2017 Earnings Call Transcript

Published: 7 Nov 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to the Mallinckrodt Q3 2017 earnings conference call. As a reminder to our audience participating in this conference, it is being recorded for replay purposes. I would now like to turn the conference over to Cole Lannum, Senior Vice President of Investor Relations. Sir, you may begin

[Coleman N. Lannum:]

Thank you, Takia, and I'd like to welcome everyone to today's call. Joining me this morning are our CEO, Mark Trudeau; and Matt Harbaugh, our CFO. Mark will start us off with some brief comments, and Matt will follow with the financials. Before we begin, let me remind you of a few details. On the call, you'll hear us make some forward-looking statements, and it is possible that actual results could be materially different from our current expectations. Please note, we assume no obligation to update these forward-looking statements even if actual results or future expectations change materially. We ask you to please refer to the cautionary statements contained in our SEC filings for a more in-depth explanation of the inherent limitations of such forward-looking statements We'll also provide some non-GAAP adjusted measures related to our financial performance. A reconciliation of these adjusted measures to GAAP is available in our earnings release and its related financial tables, which can be found on our website, mallinckrodt.com. We use our website as a channel to distribute important and time-critical company information, and you should look to the Investor Relations page of the website for this information. As noted in our press release, unless otherwise specified, all comparisons are to the comparable 2016 period. As mentioned before, the results in this quarter compare a normal 13-week period to a 14-week period in 2016. While the exact quantification of the impact of the extra selling week is extremely difficult to determine, we believe it reduced the reported quarterly net sales growth rate of the company as a whole by approximately 6 to 9 percentage points. The numbers we'll be discussing this morning make no adjustment for that comparison and are presented on an as-reported constant currency basis – again unless otherwise noted. For the third quarter of 2017, we reported GAAP diluted earnings per share from continuing operations of $0.66, compared to prior year of $1.01. After adjusting for specified items, our non-GAAP adjusted diluted earnings for the quarter was $1.97 per share versus $2.04 in the prior year. We have some short prepared remarks this morning. We'll reserve the majority of the time on the call for your questions. With that, let me turn it over to our CEO, Mark Trudeau. Mark?

[Mark Trudeau:]

Thank you, Cole, and thanks to all you for joining us today. As many of you saw at our Investor Day last month in New York, Mallinckrodt continues to make measurable progress on our strategy to fundamentally transform our business and portfolio to become an innovation-driven specialty pharmaceutical growth company focusing on improving patient outcomes in severe and critical conditions. Our increasingly diverse development portfolio presents meaningful growth opportunities over the medium term. And most importantly, if approved, these products will provide new options for fragile patients with complex, often devastating conditions. Just last week, we added another significant asset to this development portfolio, announcing we plan to acquire Ocera and its pipeline product, an ammonia scavenger, with both IV and oral formulations in development for hepatic encephalopathy, a serious and sometimes fatal complication of chronic liver disease. If approved, we expect the two formulations of this product to provide significant new therapeutic options for patients suffering from a costly, difficult-to-manage disease. Assuming approval of both formulations, we expect peak-year sales of $500 million or greater, and the asset could be one of the largest opportunities in our development portfolio. I'll discuss Ocera in greater depth a bit later. Turning to operational results, adjusting for the impact of the extra selling week in 2016, we saw solid performance across the majority of our Specialty Brands products, and the performance in our Specialty Generics segment was consistent with our expectations. However, as mentioned in our press release this morning, Acthar sales growth slowed in the quarter, impacted by both a comparison against 2016 with an additional selling week and a volume decline. Although underlying prescribing behavior, demand, remained solid, we are now experiencing what appears to be an issue more widely impacting some companies in the branded pharmaceutical industry, where an increasing number of written prescriptions are going unfilled. As we've said before, the payer environment has become increasingly complex for specialty drugs. Acthar has never been immune to these pressures, but as the third quarter progressed, we saw an increasing number of prescriptions going unfilled beyond the level we had seen previously. However, our underlying payer engagement strategy, based on expanding clinical and health economic data to establish clear reimbursement pathways for appropriate patients, has historically been very successful, and we believe continued proactive engagement will enable us to navigate these market challenges. We see early evidence that our efforts in this area are beginning to have impact and remain confident in our strategy and in Acthar's long-term growth range of mid-single to low-double digits. That being said, we anticipate it will take time to work through the situation, and we expect fourth quarter 2017 Acthar net sales to be down sequentially. We will provide further insights on Acthar in 2018 guidance for the company in the early part of next year. Looking at the hospital business, results were a bit better than expectations and solid across the portfolio. Notably, Therakos results were particularly strong, and INOMAX and OFIRMEV also performed well. Turning to Specialty Generics, while the overall business remained down from the prior-year quarter and we continue to see strong ongoing competitive pressure, our expectations for this segment on a full-year basis remain a bit better, as discussed on the second quarter call. Earlier, I mentioned our recent announcement that we plan to acquire Ocera and its developmental ammonia scavenger product with two formulations

[Matthew K. Harbaugh:]

Thanks, Mark. As Cole mentioned at the beginning of the call, keep in mind that the numbers I'm about to go through are on as-reported basis and do not take into account the extra selling week in 2016, which we believe negatively impacted the reported net sales growth rate in the quarter for the company as a whole by 6 to 9 percentage points. Our third quarter of 2017 came in with net sales of $794 million. Net sales for the Specialty Brands segment were $591 million, down roughly 7% year on year. Solid performance by our Hospital products was offset somewhat by the Acthar volumes referenced earlier. Acthar net sales declined in the quarter to $309 million, down 6%. INOMAX generated $126 million in net sales, a 1% decrease. As we've said in previous quarters, INOMAX is returning to its historical mid-single digit growth rate, off a significantly higher base than when we acquired the product. Regarding the Praxair matter, we have filed our notice of appeal and continue to believe we have strong arguments in defense of our intellectual property, along with a well-established, highly differentiated service model around INOMAX that helps ensure the durability of this product. Turning to OFIRMEV, we're continuing to see this product return to stronger growth rates, with the $75 million in net sales essentially flat over prior year. Therakos performed well in the quarter on increased net sales from the conversion of devices from the XTS to the CELLEX system, with net sales of $55 million, up nearly 2%. Looking at Specialty Generics, net sales were $189 million, a 21% decline. Our API products continue to represent roughly half of the net sales of the Specialty Generics segment. Now let me provide some details on operating expenses. Total company adjusted gross profit as a percentage of net sales decreased in the period to 72.4% from 75.3% in the prior year. We see ongoing impact on this metric, primarily due to price and volume pressures from our Specialty Generics segment. Our adjusted SG&A as a percentage of net sales was 24.9%, considerably lower than the 27.4% in the previous-year period. This result was partially driven by one-time events in the quarter, along with tight expense management, and we expect SG&A as a percentage of net sales to increase sequentially in the fourth quarter. R&D expense as a percentage of net sales was 7.5%, slightly lower than anticipated, although the percentage should increase next quarter, with the additions of inhaled xenon gas and stannsoporfin, including the one-time $10 million of upfront consideration for xenon gas. Increased investment in our growing pipeline, as Mark described earlier, will result in absolute R&D spend increasing over time in the Specialty Brands segment, in keeping with our long-term strategic commitment, although quarter-to-quarter expenditures may vary based on the timing of our clinical programs. Now, let me turn to tax. For the quarter, our adjusted effective tax rate in the period was 17%, compared to 15.7% in the prior year. I also want to address the one-time net tax benefit discussed in our press release this morning. Over the past several years, the significant acquisitions and divestitures we have made to transform our business created a complex and inefficient legal entity structure. In our continuous efforts to more efficiently manage our business, in recent weeks, we took a series of steps to simplify that structure, which in turn, under the requirements of IRS rules and guidance, resulted in a one-time tax expense of $36 million in the third quarter. 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. Of that, at least $650 million relates to our interest-bearing deferred tax liabilities. With these actions, we have now reduced the original amount of our interest-bearing deferred tax liabilities by more than $1.5 billion over the past three years, well ahead of our original expectations and primarily through the utilization of tax attributes. Looking forward, we have the flexibility to amortize the remaining liability of less than $1 billion over a period of up to 10 years. And we will continue to utilize additional opportunities to offset this liability. Turning to liquidity, we once again generated significant cash flow, with $226 million in operating cash flow, with free cash flow of $176 million. We repurchased 1.5 million shares in the quarter for $57 million, bringing the total shares repurchased for the year to 9.5 million. We have now repurchased over 19% of the outstanding shares since initiating the share repurchase program in 2016. The company also continues to strategically reduce debt as opportunities arise, with net debt repayments of $348 million thus far this year. We remain confident in our belief we have a very manageable net debt leverage ratio coming in at 3.9, as you can see posted on our website. At this point I'll turn it back over to Cole, who will take us into Q&A.

[Coleman N. Lannum:]

Thanks, Matt. As we move to Q&A, I want everyone to be aware that we have a few additional attendees here in the room available to answer your questions as they may come up. In addition to Mark and Matt, we have Dr. Steve Romano, our Chief Scientific Officer. We also have Hugh O'Neill, the President of the Acthar business. And finally we have Marvin Haselhorst, our Internal Head of Tax. I also want to remind you to please limit yourself to a single question with a brief follow-up if needed. I know a number of you are juggling multiple calls this morning. We have a very full queue of questions. So I'd ask you to please adhere to that. Feel free to put yourself back in queue afterwards. I promise we'll get through as many questions as possible in the time we have allotted. With that, operator, may we please have the first question?

[Operator:]

Our first question comes from the line of Chris Schott of JPMorgan. Your line is now open.

[Christopher Schott:]

Great. Thanks very much for the question. So I guess one for Mark and maybe Hugh. Can we just get a bit more color on the efforts to improve the fulfillment rate on your Acthar prescriptions? I guess, specifically with that question, how quickly do you think you can improve these dynamics, and are there any indications in particular that are being impacted more than others? Thanks very much.

[Mark Trudeau:]

Yeah. Thanks, Chris. Let me start and maybe just kind of frame the situation a little bit, and I'll ask Hugh to fill in some of the details. First of all, from a long-term perspective, Acthar is absolutely just fine. We continue to have solid prescription demand, including the highest prescription rates we've ever had in the second quarter. And we continue to believe that, long term, this is a mid-single to low-double digit normalized growth rate product. That's driven by patient penetration for appropriate patients and labeled indications, primarily through our payer engagement strategy and data generation. We have a couple of factors that occurred in 2016, or in the quarter in 2017. First of all, let's recognize we had a very strong 2016. We had double-digit growth rates. We also had the extra week. But what we did experience in this particular quarter, which happened kind of late in the quarter, was that we started to see an increasing rate of prescriptions written going unfulfilled through a variety of factors, both patient and payer. And typically in any given quarter, our dynamics here are pretty fluid, so we manage upsides and downsides. But because this happened somewhat late in the third quarter and spilled into the fourth quarter, and at a greater rate than we had seen before, we are likely to see volumes down in the fourth quarter, as we mentioned in the prepared comments. We've identified the issues. We know where they are. We've taken some actions already. We have seen some initial positive impact. But because of the episodic nature of Acthar prescriptions, it's going to take some time for us to recover. And it's likely going to be measured in quarters as opposed to weeks or months. So that's the overview of the situation. Again, we continue to feel very positive about Acthar. But maybe I'll ask Hugh to speak to a little bit more detail on the situation.

[Hugh M. O’Neill:]

Thanks, Mark. And thanks, Chris, for the question. So just a couple points to add a little color to Mark's comments. One is it's important to remember that the market environment for specialty pharmaceuticals outside of Acthar continues to be a bit challenging from a payer perspective. We know that the environment is focused on cost containment, maintaining those costs in line with expectations, and becoming much more aggressive in what I consider traditionally therapeutic areas where payers were not as aggressive. And we've seen that across multiple areas, and Acthar is not immune to that. To Mark's point, we've managed that into a certain area of variability since we've owned this business. And what we saw in the third quarter was a spike in the percentage of those prescriptions that were going unfilled by the patients that were prescribed the product. This spike has come across multiple channels. It's not unique to one specific player or one channel, we know. However, I think we've identified the critical drivers attached to those channels. We've begun to implement those. And we feel confident that we can turn this back to what I would consider historical levels of variability as it relates to these unfulfilled prescriptions. The reason we feel confident about it is we've done this in the past. And it's important to remember that when we took this business in 2015, there was very little – actually none, as it relates to a payer engagement strategy. In a very short period of time, we were able to put together the right type of engagement strategy, including the correct story as it relates to clinical and the benefits of the product. And as such we were able to enter into agreement with roughly 60% of the commercial lives under contract. So it's important to remember that we know how to do this. We understand how to go at this and actually get Acthar in the right type of reimbursement pathway. I want to add a little color to Mark's point about the episodic nature of the product. As we spoke about at Investor Day, you have to think about Acthar as really two pieces of patient flow, one are new patients, and the others are returning patients, as it relates to patients that are already on therapy across the various indications. What has happened as these withdrawal rates, or prescriptions going unfilled have spiked, we've lost returning patients. And because of that, it takes time to refill that patient flow with new patients. That's why we actually think it's not going to recover immediately, and as Mark said, it's more measured in a term of quarters less than the term of months. So hopefully that adds the right amount of color.

[Coleman N. Lannum:]

Thanks, Chris. Next question, operator, please?

[Operator:]

Our next question comes from the line of Marc Goodman of UBS. Your line is now open.

[Marc Goodman:]

Yes. I was curious if you could give us, on Acthar, volume versus price in the quarter. And then when you say that there are early efforts that are starting to work, can you specifically talk about what those early efforts are? And then – I know we can't ask two. But can you just comment on guidance, please? Thanks.

[Mark Trudeau:]

Yeah. So let me take again the volume versus price. I'll ask Hugh to comment on the early efforts, and then maybe, Cole, you can speak to the guidance question. In terms of volume versus price, again, we typically don't give individual numbers by product. Price was positive in the quarter for us for Acthar. And you recall, we took a nominal price increase at the beginning of 2017. We didn't take any price in 2016. And as we mentioned in the prepared remarks, volume was actually down in the quarter, due to the dynamics that Hugh explained. Hugh, maybe you want to comment on some of the early efforts that we've seen and the impact that we expect.

[Hugh M. O’Neill:]

Yeah. Thanks, Mark, and thanks for the question. So as I mentioned, we have very good visibility into where these patients are coming from and how they're flowing through the reimbursement pathway. And as a result of some of the challenges we saw in the third quarter, we're beginning to understand where some of those challenges reside. And as I mentioned, it's not just in one specific payer. It's across multiple channels. So what we've done is we've actually relooked at our overall payer engagement strategy. We've begun to think about how to take better care of those patients as they go through that reimbursement flow, and understanding how to give them the best chance to have a positive outcome before the decision is taken to withdraw or to abandon their prescriptions. So without getting into a lot of details, we know where those opportunities are. We understand what those points of engagement look like. We've begun to do that. We feel confident based on the early read that we can influence this. But most importantly, it's going to take a little bit of time to kind of get that back on track. We've identified – and as I mentioned earlier, it's not just one channel versus the other. We see this coming across multiple channels. And because we understand the flow of the patient, we have a much better picture of what's required to actually get those rates back down to historical levels.

[Mark Trudeau:]

The other thing I might add -

[Marc Goodman:]

But just so -

[Mark Trudeau:]

Go ahead.

[Marc Goodman:]

I was just going to say, just so I understand, so these are prescriptions that are actually being written and they're not getting filled.

[Hugh M. O’Neill:]

Yeah. So what happens is these are – and this is not unique. So there's been some industry publications on this issue, and we've seen this across the board. There's been a spike in what we refer to as patients who are leaving their – or not getting their prescriptions fulfilled after they go through the reimbursement process, for many different reasons. It could be because of the amount of hurdles that are put in place by the various payers. It could be because of the amount of time it might take for those patients to get access to the products. So these are patients that actually make it through the reimbursement process and are able to receive the product, and then those prescriptions are withdrawn. Now, it can come from many different areas, Marc, and I think what we've identified is where we think those opportunities are to shorten that time period, which is very important, to hopefully optimize what those hurdles look like for those specific patients. And it goes back to our initial payer engagement strategy, which is to ensuring that the payers, as well as all of the healthcare practitioners in the chain, understand who the appropriate patient is for the product. If we can clearly articulate – and that's why we feel confident about that, because of the work we've done on data generation and dissemination to identify who those appropriate patients are – we are able to optimize that reimbursement pathway. So it takes a little bit of time. We think actually by working with the payers and working with our reimbursement process that we can actually get those levels back down to historical points.

[Marc Goodman:]

But it sounds like the payers are approving the prescription. And then because it's taking so long to do that, sometimes there's just an abandonment. I mean, is that what you're saying? I'm just trying to understand the difference between the two.

[Hugh M. O’Neill:]

Yeah, Marc, that's part of it. That's part of it. We do see prescriptions approved. And because of the time, whether it's through prior authorization or through appeals or anything like that for the patient to get access to it, sometimes those patients walk away from those prescriptions. And our challenge really is to ensure that that timeline is much more manageable. And in some cases where the payer is putting pressure on, to understand where that pressure's coming from and how to remove that pressure.

[Mark Trudeau:]

Yeah. And, Marc, this isn't necessarily just an Acthar-specific situation. We've heard and actually seen reports of similar experiences for other specialty products around the industry. This impact that we've seen kind of simmering all year certainly spiked in the third quarter. And I would emphasize, it's not just a payer issue; it's also a patient issue. And I think in terms of our specific activities, we're focusing on both of those elements, and that's what Hugh refers to when he speaks to a variety of channels. There's an opportunity to enhance the patient experience. There's an opportunity to enhance the payer experience. And the reason why we feel confident that we're going to be able to turn the situation around is very simply we've done this before. We've seen this before. This came at the end of the third quarter, a bit more significant than we've seen historically. And so we're looking very carefully at all of our previous payer and patient engagement strategies, which have been very successful, and we're looking to enhance those to make an impact. And we've seen the impact of that very early here in the fourth quarter. But as Hugh said, it will take some time for us to turn this around.

[Hugh M. O’Neill:]

If I can just add one more point to that, Marc. The other thing to keep in mind is, as we've mentioned, the demand on the product, meaning the physicians' willingness to write the product, remains solid, in line with I think what we'd like to see, and that's because we've been able to work and identify who those appropriate patients are across the various indications. That's very important. So we feel confident in our ability to get the product written. I think as important to that is to ensure that we optimize the patient and payer experience so the prescription gets filled.

[Coleman N. Lannum:]

And your last question, Marc, on guidance. As you know, we never give quarterly guidance. We never update our guidance numbers after the third quarter, because a simple algebra would make that in essence giving quarterly guidance. But after the call, I urge you to do a couple things. Take a look at the press releases that we put out on the incremental M&A deals that we've done over the last couple of months, as well as review the prepared remarks, particularly those by Matt. I think what you'll find is that we've given an extraordinary amount of color that should help you get exactly where you need on the guidance side of things. Obviously, we'll give you 2018 guidance shortly into the new calendar year, and we'll address that at that time. With that, operator, can we go to the next call please?

[Operator:]

Our next question comes from the line of Annabel Samimy with Stifel. Your line is now open.

[Annabel E. Samimy:]

Hi. Thanks for taking my question. Sorry to beat a dead horse on the Acthar issue. Just to understand, so you're not seeing the problem in terms of patients getting approval for the drug. So it doesn't seem like it's a prior authorization that's caused them to not fill the prescription. So to me, in that situation, it feels like it has to do with either co-pays or some kind of monetary impact to the patient that's making them walk away. So if you're addressing both the patient and the payer experience, from the patient perspective, are you going to be addressing some of these issues by providing more patient assistance? And what can we assume going forward on a longer term basis, what the net price of Acthar can be going forward? Is this going to have a permanent impact on Acthar going forward, is what I'm wondering.

[Mark Trudeau:]

Yeah. So let me take the – kind of the long-term question, and then I'll ask Hugh again to give some more color on some of the nearer term. Let's recognize, first of all, that as we've said many times throughout the year, Acthar like all specialty pharmaceutical products to the best of our knowledge continues to experience payer pressures. We expect those payer pressures to continue to be more challenging. We expect payers to put more and more hurdles in front of patients getting reimbursement. That is something that I think is pretty common across the specialty arena, and Acthar is no different. The situation that we're experiencing now is this combination of both those payer pressures plus the additional issue that we're seeing with these patient prescriptions going unfulfilled or unfilled at this point. Again, I'd go back to the fact that we believe quite strongly that the long-term normalized growth rate for Acthar is in the mid-single to low-double digit range, and nothing is changed. We believe that is likely to be the case because of a couple of reasons. One, we have relatively low patient penetration rates, even for our labeled indications for appropriate patients. We've had a very successful payer engagement strategy up until this point. We continue to have very good success, and we've referenced throughout the course of 2017 that we've had formulary restrictions lifted on Acthar in some cases. In at least one case, we've had a significant de novo formulary addition for Acthar. And we continue to generate significant data for the product, which we believe supports the appropriate positioning for Acthar for primarily refractory patients. Over time, we would expect that the net price impact on Acthar will continue to experience pressure, as our quite successful contracting strategy continues to drive volume. So over time, again, we continue to see this as a very solid mid-single to low-double digit growth rate product.

[Hugh M. O’Neill:]

Yeah. Just a little color on that. I think it's important to remember, as Mark said, that there's always been payer pressure on this product, on the Specialty segment in general. We've been able to navigate some of that pressure because we've been committed to this whole idea of data generation and dissemination. Remember, the idea here is that the payer wants to understand who the right patient is that should get access to the product. It's our obligation to be able to communicate that through the data generation that we have, to be able to demonstrate that value. Now, there has been, and there will continue to be, more hurdles thrown in place of not only Acthar, but other specialty products, and those come in the form of prior authorizations, as well as potential appeals. But what's also important to remember, as we said, is that we are actually supportive of prior authorization on this product, that actually this is a third- or fourth-line product used across its indication, with the exception of IS, and really used for refractory patients for the most part. And because of that, our job is to work with the payers to understand what that reimbursement pathway should be. That takes some time. So it is a combination of some reimbursement challenges, but also challenges that we knew were there and manageable, and then at the same time, trying to help the patient through the entire process, so by the time they get to the end of the reimbursement pathway, that they're able to receive the product. So we know, I think, what needs to be done. We've been able to establish that in our payer engagement strategy. We've upgraded our patient engagement as well, and we feel confident that we can navigate this. But there are market pressures that are not unique just to Acthar, and will require us to continue to stay diligent.

[Mark Trudeau:]

And, Annabel, just quickly, you asked about more PAP. What I would say here is that we participate appropriately in the variety of programs that are available for patients, regardless of their payer type. We believe that is an appropriate therapy – or an appropriate approach to ensuring that patients that can benefit from therapy can get access to the product. So we would continue with that strategy going forward.

[Annabel E. Samimy:]

And can I just ask a quick follow-up? Is the population that's being impacted more in the commercial pay market or in the government pay market?

[Mark Trudeau:]

Specifically, we're not commenting on any specific payer or even class of payer at this point, other than to explain the dynamics that are driving the current situation for Acthar. And again, as we said, we've identified what we believe are the very specific issues that drove the third quarter and early fourth quarter impact. We're addressing those, and we're moving forward with actions where we're already seeing some positive benefit.

[Annabel E. Samimy:]

Okay. Thanks.

[Coleman N. Lannum:]

Thanks, Annabel. Next question, please.

[Operator:]

Our next question comes from the line of Anthony Petrone with Jefferies. Your line is now open.

[Anthony Petrone:]

Thanks. Sorry to stay on Acthar here. Just a few follow-up questions. I guess, is there any shift by indication? So is there any specific indication where you're seeing pressures, whether it be an increase in prior authorization hurdles specifically, or just prescriptions not going through on appeal? And then the follow-up would be, we're – and I know you just mentioned not going to mention anything by payer. But on the commercial payer side, were there are any specific changes of note? Thanks.

[Mark Trudeau:]

So on the indication-specific, I'd say that we probably see some modest difference by indication, not particularly significant to note, however. I would say certainly IS, infantile spasms, tends to be completely unaffected by payer pressures or patient pressures in general. Otherwise, there are some modest differences between indications, but nothing major to note. In terms of any specific commercial changes, again, at this point, we continue to be very pleased with what we've been able to do with regards to percent of commercial lives under contract, for example, with the activities, the positive momentum that we've been able to drive, particularly with commercial payers, through our payer engagement strategy. And again, beyond that, we can't really comment on any specific payers or payer class at this point.

[Anthony Petrone:]

Thanks.

[Coleman N. Lannum:]

Thanks. Next question, please.

[Operator:]

Our next question comes from the line of Douglas Tsao with Barclays. Your line is now open.

[Douglas Tsao:]

Hi. Good morning. Thanks for taking the questions. Just to maybe change the topic. Just turning to INOMAX performance, it was solid but we've sort of been stuck in this sort of mid-120s range for a number of quarters now. You've had a lot of success in the early days after acquiring Ikaria in terms of your contracting strategy. As you've sort of upgraded a lot of institutions, and that was obviously a key driver of growth, are you just sort of now forced to where you sort of need to – or is growth going to be much more focused in the sort of install base?

[Mark Trudeau:]

Yeah. So again, just a little history for INOMAX. As you know, it's historically had a growth rate in the mid-single digit range. We believe that's actually the normalized growth for this. In 2016, we had an outstanding year. I think we had mid-teen growth that was driven by two primary factors. One was that the AHA and ATS came out with guidelines that supported additional use or extended use, in some cases, for nitric oxide in certain patients. We clearly believe we benefited from that. We also believe we benefited in 2016 from a change in our customer contracting and engagement strategy, and that had, certainly, an impact in 2016 that carried over into the early part of 2017. We're now kind of in the normalized growth rate range for INOMAX. We continue to make good penetration in the proportion of patients in the NICU that are treated with INOMAX, and we would expect that mid-single digit growth rate will be where we're likely to be, albeit on a much larger base than we had before. And remember that we are present in the majority, if not the census, of the top NICUs in the U.S. And so, our growth is still likely to come from that installed base. But recognize that we've still got significantly less than 100% patient penetration in those NICUs, so there's plenty of opportunity for growth long term.

[Douglas Tsao:]

Okay. Great. Thank you.

[Coleman N. Lannum:]

Thanks, Doug. Next question, please.

[Operator:]

Our next question comes from the line of Gary Nachman with BMO Capital Markets. Your line is now open.

[Gary Nachman:]

Hi. Good morning. If there's going to be some additional pressure on Acthar for a few quarters, does that change how you think about capital allocation at this point? Can you look to bolt-on assets just as aggressively as you've been doing in due dilutive (41

[Matthew K. Harbaugh:]

Gary, it's Matt. Thank you for the question. I would say no. We are still generating a lot of cash. As you saw, we generated $226 million in operating cash in the quarter. That's on the heels of an exceptionally strong second quarter as well. If you actually look at our underlying results in the first quarter, the impact there was the FTC settlement and other kind of one-time payments. So we've been generating a lot of cash throughout the year, and we expect those cash flows to continue to be strong. I'm sure you noticed in the release this morning we have put in rigorous expense controls as well, which also allows us to generate cash. And as we look for 2018 from a cash perspective, we still foresee the horizon to be strong. We also will get $154 million in for the sale of our Intrathecal business in the New Year. So we feel like we've got plenty of flexibility to operate. And really we focus on the returns of any cash that we deploy.

[Mark Trudeau:]

Yeah, Gary. I might just add, it should be quite clear at this point that we're really transforming Mallinckrodt into really an innovation-driven company. As you've seen throughout the course of 2017, we've really started to build a very diverse pipeline of what we believe are significant opportunities for the near and mid-term. The cash flow that we generate from our in-line products will help to develop those pipeline products. We want to continue to build diversification depth and breadth in our pipeline and also depth and breadth in our product line. And as Matt described, we have plenty of firepower to be able to do that. So we want to take this opportunity, again, to continue to take another strong step forward in making Mallinckrodt an innovations-driven specialty pharmaceutical growth company that's really focused on patient outcomes, particularly for serious and complicated conditions, and importantly that we're driving significant value for the healthcare system as a result of focusing on these patients that have relatively few options.

[Gary Nachman:]

Okay. A quick follow-up. Where are most of the expense controls coming from? Where are you scaling back a little bit?

[Matthew K. Harbaugh:]

Yeah. You definitely see it in the SG&A that we posted this morning. It was lower than what our internal forecast was. From an R&D perspective, we were low in the quarter as well, but we expect that to pick up in the fourth quarter because of the three developmental deals that we've signed over the last quarter, xenon gas, stannsoporfin, as well as the asset we added last week, Ocera. Although Ocera may or may not close in this quarter, but there will be some deal expenses related to that transaction.

[Coleman N. Lannum:]

Thanks, Gary. Next question, please.

[Operator:]

Thank you. Our next question comes from the line of David Maris with Wells Fargo. Your line is now open.

[David Maris:]

Good morning. Wanted to talk a little bit about taxes. So the new tax reform proposals – and I know you can't be specific because they're just – they're not specific, and who knows if really been passed. (45

[Matthew K. Harbaugh:]

Good morning, David. So I'll start, and then I'll turn it over to Marvin Haselhorst, who's our tax expert here at the company. The first thing I would say is it's way too early. We got to watch this play out in the coming weeks and months. I would also add as we see it as it stands today, there are some positives for us and some negatives, and we're navigating both. And there's, I'm sure, lots of stakeholders that are communicating up to Washington around what they like and dislike here with some of the proposals. So it is really early. So I would just say it's hard to predict. But with that, let me turn it over to Marvin for him to provide his own viewpoint.

[Marvin R. Haselhorst:]

Thanks, Matt. So as Matt mentioned, it is very early in the process. We have been engaged through various trade associations and our own interactions with members of Congress and their staff. We're monitoring it closely. The overall themes of competitive tax system for the United States and the impact on multinational corporations as ourselves is very actively being discussed in Washington, and we're engaged in those discussions. So obviously you understand we're a multinational organization, so we monitor those provisions in particular. Obviously, the rate itself has been discussed to be dropping significantly from 35% to 20%. So that's a good guy that we would anticipate coming through. But as Matt said, there's going to be good guys here and bad guys here. And we don't really want to comment at this early stage and sort of poison the discussions, if you will. We want to look at this thing overall as it develops and then be able to provide positive or constructive feedback into the processes as this advances.

[Coleman N. Lannum:]

Thanks, David.

[David Maris:]

Thank you.

[Coleman N. Lannum:]

Thank you. Next question, please.

[Operator:]

Our next question comes from the line of Dana Flanders with Goldman Sachs. Your line is now open.

[Dana Flanders:]

Hi. Thank you for the questions. Just my first one here, can you explain just the mechanics of the legal entity restructuring and just why this is being done now? And are there other ways to lower your deferred tax liability by noncash means, or should we assume on a go-forward basis that this will be paid down with operating cash flows? Thank you.

[Matthew K. Harbaugh:]

Yes. I would like to start by – sorry, we got an echo. I'd like to start by echoing what I said in the prepared remarks, which is we did see a tax expense of $36 million in the quarter – in the third quarter, that is – and we do expect to see a one-time tax benefit in excess of $800 million in the fourth quarter, which you'll see filed in our 10-K ultimately in early 2018. And so of that, there's $650 million that relates to our interest-bearing deferred tax liabilities, what we call 453A interest expense. And so you will see a decrease in that expense as we move into 2018 due to the fact that a fair bit of this legal entity restructuring reduces that future liability. But with that, let me turn it over to Marvin for more color.

[Marvin R. Haselhorst:]

So the entity reorganization that we announced today as a subsequent event to the third quarter will be finalized within the fourth quarter – actually has been finalized already. That represents just one opportunity that there is to lower the deferred tax liability through noncash means. There are others that we've taken advantage of the past. And I expect, to the extent there are opportunities in the future, we will be able to identify those and take advantage of them as well in the future. As Matt said in his prepared remarks, with today's actions, or with the reorganization, we've now reduced the original balance of the deferred tax liability from over $2.5 billion to less than $1 billion now. And so most of that reduction, actually a third, through noncash means. You can actually see this in our reported financial statements, the amount of total taxes that we paid during that period – total cash tax payments during that period were less than half of the reduction in DTL. So the numbers are out there. They speak for themselves in terms of the opportunities that are available to reduce this liability through noncash means going forward.

[Matthew K. Harbaugh:]

It's also important to add that we do have 10 years here to chip away at the remaining liability, and this is not debt. It's not like we have fixed payments that we're going to have to make in future years. It's been mischaracterized, in my mind, for a number of months.

[Marvin R. Haselhorst:]

And there's one other point that needs to be made with respect to the deferred tax liability, is the reduction in that, the amortization of that liability, whether by cash payments or noncash means, actually goes through our non-GAAP reported tax rate. So to the extent you're using that rate in DCF models or in leverage ratios, you need to understand that we have already included in our non-GAAP effective tax rate the reductions in that DTL as it occurred in the past, and any guidance that we've given always anticipates that we would be reducing that – the effect of reducing that liability is coming through our non-GAAP rate.

[Coleman N. Lannum:]

And, Marvin, Dana also asked why now – why is this happening now?

[Marvin R. Haselhorst:]

So the opportunity to execute on this particular type of reorganization wasn't available to us until late September, early part of October of this year due to we needed a holding period to lapse, and at which point we were able to move forward with this transaction. So that's really the short of it, is until that holding period passed, we couldn't move forward with this particular reorganization.

[Coleman N. Lannum:]

Perfect. Thanks, Dana. Next question, please.

[Operator:]

Our next question comes from the line of Dewey Steadman with Canaccord. Your line is now open.

[Dewey Steadman:]

Hi. Can you just give me your thoughts on developed assets or development stage assets versus on-market assets for business development? Obviously there's been a number of interesting deals for (51

[Mark Trudeau:]

Yeah. Thanks, Dewey. So from a business development perspective and a overall portfolio development perspective, as I've said many times before, our objective is to have a well-diversified commercial portfolio and a deep and broad pipeline. And recognize that we didn't start with either one of those when we spun just four and a half years ago. And so along the way we've been acquiring both commercial assets to provide diversification cash flow and infrastructure in which to launch development assets, and more recently, we've been acquiring development assets. Longer term, we've been very clear to say we want no single product to account for more than a third of our operating income, and we will get there both through the commercializations of development assets, as well as acquiring other commercial assets. So any given point in time, we are looking for assets, either commercial stage or development stage, that fit our strategic objectives. It just so happens in the last couple of transactions, we've been able to identify some very attractive development assets, but we would expect going forward to be continuing to enhance both our commercial and development portfolio.

[Dewey Steadman:]

Thanks.

[Coleman N. Lannum:]

Thanks. Operator, next question, please.

[Operator:]

Our next question comes from the line of Elliot Wilbur with Raymond James. Your line is now open.

[Elliot Wilbur:]

Good morning. A question for Matt. Wondering if you could just provide any color commentary on trends in segment profitability for the quarter, specifically thinking about sequential trends. Obviously, we saw a nice bounce in operating margin, which really was driven by the SG&A leverage. I'm not sure if that's tied to one particular segment or if that's more of a corporate allocation issue, but just a color commentary on the trends in segment profitability. And then with respect to the Generics segment, how closely do the segment profitability numbers disclosed in the quarterly filings match what we would consider to be adjusted EBITDA metrics? Thanks.

[Matthew K. Harbaugh:]

Sure. So let me just kind of walk through some of the line items in the P&L. So as you're looking at our gross profit, it dropped – gross profit as a percent of sales, that is – it dropped. And that was almost entirely driven by the challenges we have in Specialty Generics from a price perspective. It still remains very competitive out there. From a SG&A, I would say that was kind of across the board, probably more weighted to what I would call corporate and to our Specialty Brands business. As I'm sure you're aware, generic businesses tend not to have a lot of G&A, SG&A associated with them. Keep in mind, our Generics business, we don't promote products. So it's more of a business-to-business model that we operate. R&D, I would say we kind of have two things going on. We've seen some benefit in our Generics business, a little less spending than what we've seen historically, and some of that's been offset in brands. But as I said earlier, you're going to see that pick up as we move into future quarters with the development deals that we've signed or hope to close on in the near term. As we look to 2018, I mentioned earlier you'll see interest expense likely come down. That's driven by the fact that we have been paying off some debt this year in addition to the 453A interest that I mentioned earlier. So those would be kind of the line items and how you should think about them. I'd say from a profitability perspective, there's a lot of unallocated cost at the corporate level. So I would say the way we think about our segments is the numbers that we put out are how we manage the business, and that's where we charge the businesses for direct costs. People that spend all day every day focus on Brands or Generics, whereas folks like myself or Cole or Mark, we don't allocate those costs out between the businesses. So, if you're trying to take the operating income and use it as a proxy, you're mischaracterizing what the underlying cash flow would be out of that business.

[Coleman N. Lannum:]

Thanks, Elliot. Next question, please.

[Operator:]

Our next question comes from the line of Gregg Gilbert with Deutsche Bank. Your line is now open.

[Gregg Gilbert:]

Yes. Hi. Thank you. If you were to divest the Generics business, Matt, can you talk about deployment of those funds and whether you think about that type of capital deployment differently from how you characterized your current priorities, based on cash flow deployment? And maybe a pipeline question on the HE product. Can you talk about where that would fit in versus lactulose and rifaximin? Thanks.

[Matthew K. Harbaugh:]

Yes. Let me start with your capital allocation question, and then I think Dr. Romano will answer your other question. From a capital allocation perspective, Gregg, we would look to put that capital back to work. We would likely not sit on any sort of proceeds, much like you've seen with the Nuclear divestiture, the CMDS divestiture, and to a lesser extent, the Intrathecal divestiture. And that's why we have been able to aggressively pay down debt. I would also add, with the cash flows being so strong this year, we've also significantly derisked the balance sheet, whether it be legal settlements. I'm sure you recall in the first quarter, we also derisked the pensions to the tune of about $70 million in cash. And all of this is aiding us in reducing our SG&A expense burden, which is something that we've been very focused on for a number of years. That's why we have the restructuring programs. So we're really trying to continue to drive cash flows wherever possible. So, hope that answers your question. We are very active in business development, as you've seen with the deals that we've done in the last couple of months. So with that, I'll turn it over to Dr. Romano.

[Steven Romano:]

Yeah. No, thanks for the question, and I always enjoy responding to a question about our development portfolio. So Ocera, as compound OCR-002, is really our latest addition to our growing pipeline of over 12 programs, half of which are in late-phase development, and this will add to that latter group. So we're very excited about that. As you might know, lactulose and rifaximin, they're both used for different stages of treatment of hepatic encephalopathy, and they indirectly affect ammonia. So lactulose is a laxative, and rifaximin is an antibiotic. The latter has an indication for prevention of recurrence. It's sometimes used in the hospital on top of lactulose to control acute hepatic encephalopathy in those hospitalized patients. We anticipate that our product will be used on top of lactulose in the acute setting – that's for the IV. The unique mechanism there is really kind of exploited by the availability of an IV formulation. So you can get to the proper exposures and level of the product relatively quickly. We think we can optimize that in our Phase III treatment strategy and the design of that trial, so you can get rapid reductions of ammonia even on top of lactulose. So we're confident we're going to be able to demonstrate the benefit on top of lactulose. For rifaximin, we think we have – we will potentially, with the oral compound, have a better-tolerated product and, again, one that's acting more specifically and directly on ammonia. So we think we can fit it into the treatment of hepatic encephalopathy as a unique addition, and hopefully a superior one.

[Gregg Gilbert:]

Thanks.

[Coleman N. Lannum:]

Thanks, Gregg. Operator, we're going to try to get a couple more questions here real quick before the bottom of the hour. Next question, please.

[Operator:]

Our next question comes from the line of David Risinger with Morgan Stanley. Your line is now open.

[Onusa Chantanapongwanij:]

Good morning. Thank you. This is Onusa calling in for Dave. Would you please provide some perspective on the transition of branded franchise support in New Jersey and discuss SG&A cost efficiency opportunities ahead? Thank you.

[Mark Trudeau:]

Yes. So let me start. So we, just this year, actually opened up a facility in New Jersey, that is the headquarters for our U.S. branded business. This is a facility in which we're able to consolidate a number of the acquisitions that we've made throughout the course of the last couple of years, many of which were based on the East Coast. It also gives us a great opportunity to consolidate both our commercial operations and our science and technology operations around brands in one place. We've completed that transition at this point. And so going forward, we think we're in a very good position to continue to operate that branded business from a New Jersey location. Matt, I don't know if you want to comment on the SG&A opportunities.

[Matthew K. Harbaugh:]

So I wouldn't limit your thinking to SG&A. We also are always looking to be efficient, whether it be in R&D or cost of goods sold or in our tax line. So we're looking to be maximally efficient to drive return for shareowners anywhere possible. One of the benefits we've seen, both with the footprint move to Bedminster that you asked Mark about, is that we've been able, as we've been moving the businesses and as we've done these acquisitions, we've been able to consolidate a lot of our work and really get at our cost structure. And you see the benefit of that today in the SG&A line from a cost savings perspective in the quarter. So we did say that it was kind of unusually low. We had some one-time adjustments in the quarter. But again, if you look at where our SG&A was a couple years ago and you look at where it is today, we've been very effective in removing cost while still being able to operate the business.

[Coleman N. Lannum:]

Thanks, operator. Let's – next question, please.

[Operator:]

Our next question comes from the line of Louise Chen with Cantor. Your line is now open.

[Louise Chen:]

Hi. Thanks for taking my question here. I just had a question on how to think about the operating expenses for the remainder of the year and going into 2018. So, first of all, with respect to the R&D expenses, can you talk about the magnitude of incremental spend as a result of the announced transactions this year? And can those be offset with any other R&D savings? And then on the SG&A, can you quantify the magnitude of the one-time benefits of SG&A this quarter, if there were any? And then, if there's still room to address some of these nuclear medicine leave-behind costs? Thank you.

[Coleman N. Lannum:]

So, again, we're not going to give too much detail on that. I would refer you, Louise, to the press releases that we put out on the acquisitions. We actually did give a lot of detail there. That's the best metric to think about on the R&D side of things. When we put those releases out, we were looking at incremental kinds of spending, and while obviously there are a lot of things that go into R&D, that's what you should think about in terms of the impact on the EPS, and that's what you should think about in terms of R&D. In terms of the SG&A spending, as Matt said, it is going to be up incrementally in the fourth quarter. Obviously, SG&A came in way below our expectations this quarter. Some of it was around some of the savings on the leave-behind costs, but some of that was on the one-time side as well. We don't want to quantify it too much except to say, as noted, it would be up sequentially into the fourth quarter. Operator, let's try to get one last question, and then we'll need to wrap, please.

[Operator:]

Our final question will come from the line of David Amsellem with Piper Jaffray. Your line is now open.

[David A. Amsellem:]

So I know you've covered this in a number of different ways, but I just wanted to get some more detailed thoughts on why you continue to focus on the repurchase of shares, and can you or will you focus on accelerating debt paydown, particularly given that these pipeline-related acquisitions don't carry a lot in the way of upfront payments? Thanks.

[Matthew K. Harbaugh:]

Yeah. So you'll see that our share repurchases did moderate a bit in the last quarter. Keep in mind, we were doing a number of transactions throughout the quarter, and we were wanting to make sure that we were keeping our net debt leverage in check. And we did have some cash go out the door. If you think about the stannsoporfin acquisition, for instance, that was $80 million. So we're trying to be very good stewards of the capital that we have. As it relates to what we're going to do in the future, we really don't speculate as to what we're doing. We monitor credit spreads very aggressively. And obviously we pay close attention to what's going on with the share price, and we balance that against any business developments that we have underway.

[Mark Trudeau:]

Yeah. And I think just to conclude here, David. I think Matt's right on with regards to use of capital regarding various financial levers that we might pull. But, fundamentally, we believe that the best use of our capital continues to be to build and diversify our portfolio. Let's recognize we're still a construction project. We're in the middle of transforming this business. We've made some dramatic transformations in divesting lower-margin, low-growth businesses, substituting those for a higher-margin, higher-growth businesses, and simultaneously building a pipeline. We want to continue to do that. We believe that we have a ways to go yet. And with our cash flow generation and other opportunities that we have in our portfolio, we continue to believe that that's the best way to generate long-term shareholder value. Let's recognize also that in building the portfolio, the pipeline, we mentioned at the Investor Day that if all of the things in our pipeline were to come to fruition, we're looking at the potential of over $1 billion in peak-year sales. That was before we added the Ocera product, which now would take that number over to $1.5 billion. So we think we're well on our way, but we have a lot of work to do still, and we would continue to prioritize diversifying business development as the number one use of capital going forward.

[Coleman N. Lannum:]

David, thanks a lot. And we're going to cut off there with (1

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone have a great day.