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Morningstar | Shares in Mayne Pharma Look Fairly Valued; Maintaining our FVE

We maintain our AUD 1.30 per share fair value estimate for no-moat Mayne Pharma, and our very high uncertainty rating, after transferring coverage to a new analyst.

Our long-term outlook is mostly unchanged. We continue to expect Mayne will continue to build scale by capturing profitable and sizable market shares in niche drug segments, through new product introductions or acquisitions that can sustain only a limited number of participants. To this end, we’re encouraged by the company’s number-one or number-two positioning in 60% of its generic product portfolio. Moreover, a recently improving pricing environment in generics suggests the competitive landscape is returning to more normal levels. We think the company’s strategy of targeting niche markets will offset continued competition in oral contraceptive products and assume six new generic products launched in fiscal 2018 will provide an uplift to revenue in the generics division going forward. We forecast revenue in this segment climbing at about 0.4% per year through fiscal 2023 and expect the ongoing transfer of third-party manufactured products to Mayne’s U.S. manufacturing plant driving gross margins toward 56% by 2023, from 46% in fiscal 2018.

Similarly, we forecast sharply increasing sales in the specialty brands division. Although this segment only made up 8% of revenue in fiscal 2018, compared with 73% for generics, we see recent momentum continuing given the company’s decision to expand the team to 114 sales representatives. Including the recently acquired Efudix product, we expect this division to generate a five-year revenue CAGR of 19%. As this segment’s revenue is higher-margin, we expect positive mix shift to lift consolidated gross margins to about 60% by fiscal 2023, from 48% in fiscal 2018, with EBITDA margins expanding to nearly 35% from an adjusted 31%.

We don’t believe Mayne has carved an economic moat. Sources of competitive advantage for generic drug manufacturers, as opposed to those for traditional drug businesses, typically include economies of scale and vertical integration, combined with unique formulation skills, complex generics expertise, and broad geographic reach. In the absence of patent protection afforded to innovative drug developers, these factors represent comparable barriers to entry. Mayne Pharma's transformational acquisitions have combined several of these aspects, including good manufacturing practices and compliant commercial manufacturing operations accredited to handle high-potency substances in both Australia and the U.S. However, we believe the firm’s products lack the complexity needed to command strong pricing power. This is evidenced by recent pricing pressure faced in the generics product division, limiting returns on invested capital, including goodwill, to 7% in fiscal 2018 by our estimate, below the firm’s cost of capital.

Offsetting these concerns, Mayne Pharma is in sound financial health. We remain comfortable with gearing levels and forecast the company's operating cash flow conversion ratio averaging a solid 200% of net income over the next five years. While capital expenditure demands on cash flow are relatively light, research and development, or R&D, spend is much greater. Most of Mayne’s research spending is capitalised--roughly 73% in fiscal 2018--with the remainder expensed. Nonetheless, we expect free cash flow to remain strong, supporting further acquisition opportunities.