S&P Lifts Outlook on Mallinckrodt (MNK) to Positive; Sees Leverage Improving in 2016

Standard & Poor's Ratings Services affirmed its 'BB-' corporate credit rating on Mallinckrodt PLC (NYSE: MNK) and revised the outlook to stable from negative. We also affirmed all existing issue-level ratings on Mallinckrodt's outstanding debt. The recovery ratings are unchanged.

"The outlook revision reflects our assessment that Mallinckrodt will be able to improve its leverage to the mid-4.0x range in 2016 as a result of increased profitability and strong cash flow generation, despite its continued appetite for medium-size acquisitions," said Standard & Poor's credit analyst Maryna Kandrukhin.

The company's 2015 EBITDA margin expanded to 39.5%, compared to our previous projection of 31.5%, following successful acquisition/integration of higher-margin branded products and recent divestiture of the lower margin contrast media and delivery systems (CMDS) business. We expect the company to sustain its margins at the improved level and are revising our 2016 adjusted leverage projection to 4.5x, modestly lower than our previous projection of 4.9x and consistent with our current assessment of its financial risk profile as aggressive.

The stable rating outlook reflects our expectation that 10% revenue growth, increased EBITDA margins, and strong cash flow generation will result in Mallinckrodt's leverage improving to 4.5x in 2016 and sustained in that range going forward.

We could lower the rating if there is a risk to the expected improvement in the company's 2016 credit measures. Such risk could materialize if the company's operating performance deteriorates due to increased competition and intensifying pricing pressures resulting in flat revenues and a 300-basis-point margin contraction. In addition, more aggressive financial policy manifesting through additional debt-financed acquisitions or share repurchases and resulting in leverage above 5.0x could lead to a downgrade. We estimate that a transaction that results in additional $1.4 billion in debt (on top of $1 billion of acquisitions included into our base case projections) would alter our expectation for the company's long-term leverage levels and lead to a downgrade.

We could raise the rating if Mallinckrodt successfully grows its product portfolio and product pipeline or adds blockbuster drugs, although this would have to be done to a degree that would prompt reconsideration of the company's business risk. We could also raise the rating if EBITDA growth is higher than our base-case expectation (from higher revenues or margin expansion of 300 basis points) and, when coupled with accumulation of cash (or debt repayment), results in leverage of 4x or less. Commensurate with this scenario would be management's commitment to maintain leverage at or below 4x. We view the current pace of acquisition activity to be aggressive and this strategy could limit upside potential over the next year.

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