King Pharmaceuticals sells brand-name prescription pharmaceuticals. King suffered a major blow this September when a U.S. Court of Appeals invalidated a patent covering Altace® (a registered trademark of King Pharmaceuticals). This ACE inhibitor, which is used to treat patients with cardiovascular risks, had accounted for about 1/3 of King's net sales. A decline in the price of KG shares, which had started during the summer, accelerated when the news of the ruling became public. At about $11 each, KG shares now sell for less than 1/2 of their 52-week high and less than 1/4 of its all-time high.
The court ruling led King to record pre-tax charges, primarily related to Altace® asset impairment, of a massive $264 million. It also led King to accelerate a strategic plan to increase the company's focus on certain specialty pharmaceutical markets. This corporate restructuring includes a layoff 20 percent of staff.
The patent invalidation is just the latest in a long series of ills afflicting King. There have been Medicaid overcharge allegations, inventory management challenges, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections. Just the other day, the SEC closed a long-running investigation into whether King underpaid rebates owed the Government. King is still facing the looming loss of patent protection on key products other than Altace®.
When we analyzed King after the June quarter, the Overall gauge was 52 points, a good score. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 14 points. Growth and Value were weakest at 12 points each.
Now, with the available data from the September 2007 quarter, our gauges display the following scores:
- Cash Management: 22 of 25
- Growth: 17 of 25
- Profitability: 16 of 25
- Value: 22 of 25.
- Overall: 78 of 100.
Before we examine the factors that affected each gauge, let's review the latest quarterly Income Statement. Given the uncertain state of how the Altace® decision would affect King's finances, we did not issue a pre-release earnings prediction for September quarter.
| ($ M) | September 2007 (actual) | September 2006 (actual) | |
| Revenue (1) | 545 | 492 | |
| Op expenses | |||
| CGS (2) | (198) | (106) | |
| Depreciation | (37) | (38) | |
| R&D | (35) | (38) | |
| SG&A (3) | (185) | (158) | |
| Other (4) | (168) | (28) | |
| Operating Income | (78) | 123 | |
| Other income | |||
| Investments | (10) | 0 | |
| Interest, etc. | 8 | 7 | |
| Pretax income | (80) | 130 | |
| Income tax | 40 | (40) | |
| Net Income | (41) | 90 | |
| ($0.17)/sh | 0.37/sh | ||
2. Cost of revenues, exclusive of depreciation, amortization and some impairments.
3. SG&A plus co-promotion fees.
4. $148 million asset impairment charges; the rest is mostly restructuring charges
King's Revenue in the recent quarter was 10.8 percent greater than in the year-earlier period. The Cost of Goods Sold (CGS) was 36.3 percent of Revenue, compared to 21.7 percent in September 2006 and a five-year median value of 25 percent. CGS soared because it includes $82 million of impairment charges associated with Altace® inventory. CGS drops to 21.3 percent of Revenue in the recent quarter if the impairment charge is excluded.
Depreciation expenses were 6.7 percent of Revenue, down from the year-earlier value of 7.7 percent. Research and Development (R&D) expenses were 6.4 percent of Revenue, compared to 7.8 percent in September 2006. Sales, General, and Administrative (SG&A) expenses were 34 percent of Revenue; SG&A was 32.1 percent of Revenue one year ago.
Other operating expenses included $148 million in charges due to impaired Altace®-related intangible assets and $20 million restructuring charges.
As a result of the asset impairment and other special charges, Operating Income and Net Income both fell into negative territory.
If that wasn't bad enough, King also incurred a $10.5 million loss on an investment in Palatin Technologies, Inc. The investment was associated with a collaboration agreement that has since been terminated.
Cash Management. This gauge increased from 13 points in June to 22 points now.
All of these measures helped the gauge were:
- LTD/Equity = 16.3 percent; relatively low and down from 17.8 percent in Sept 2006
- Inventory/CGS = 112 days, compared to 156 and 196 days 3 and 12 months ago, respectively. A substantial impairment charge slashed the inventory level.
- Cash Conversion Cycle Time (CCCT) = 107 days, down from 171 days a year ago; the inventory write-off also creates an artificial appearance of improved efficiency
- Debt/CFO = 0.7 years, compared to 0.7 and 1.0 years 3 and 12 months ago, respectively
- Working Capital/Market Capitalization = 37 percent, up from 21 percent.
- Days of Sales Outstanding (DSO) = 45 days, down from the 49 days one year earlier
- Current Ratio = 3.7; too much of a good thing, it was 2.7 in Sept 2006
- Finished Goods/Inventory =20.1 percent; it was 30.7 and 29.6 percent 3 and 12 months ago, respectively.
Growth. This gauge increased from 12 points in June to 17 points now.
The measures that helped the gauge were:
- CFO growth = 44.5 percent year-over-year, up from -18.8 percent.
- Net Income growth = 12.8 percent year-over-year, up from -30.3 percent.
- Revenue/Assets = 62.7 percent, up from 58.5 percent in a year.
Net income benefited from a change in the income tax rate from 32 to 26 percent.
The measures that hurt the gauge were:
- Revenue growth = 11.5 percent year-over-year, down from 12.2 percent.
Profitability. This gauge increased from 14 points in June to 16 points now.
The measures that helped the gauge were:
- FCF/Equity = 22.1 percent, up from 16.0 percent in a year
- Accrual Ratio = -10.9 percent, down from -6.2 percent in a year.
The decreasing Accrual Ratio tells us that more of the company's Net Income is due to CFO, and, therefore, less is due to changes in non-operational Balance Sheet accruals.
The measures that hurt the gauge were:
- Operating Expenses/Revenue = 75.7 percent, up from 68.2 percent in a year.
- ROIC = 13.5 percent, down from 16.3 percent in a year.
The increase in operating expenses was the result of the inventory charges allocated to Costs of Goods Sold.
Value. King's stock price dropped precipitously over the course of the quarter from $20.46 to $11.72, which caused the Value gauge to soar to 22 points from 12 points three months ago.
All of these measures helped the gauge:
- P/E = 16.1, well below its five-year median value of 26.4
- P/E to S&P 500 average P/E = a slight discount, compared to a five-year median of a 60 percent premium.
- Price/Revenue ratio = 1.3, much less than its median of 2.3.
- Enterprise Value/Cash Flow = 3.6, less than half its median value of 8.6
The average P/E for the Biotechnology and Drugs industry is an expensive 31. The average Price/Revenue for the industry is 8.5.
Under other circumstances, we would view an Overall Gauge score of 78 out of 100 possible points as a bright neon sign indicating that a company is both performing superbly and has an undervalued stock price. Unfortunately, this is one case where past performance is not only no guarantee of future results, it is pretty much certain that King Pharmaceuticals' future is going to be very different from its past. Because of the unfavorable patent ruling, King is going to have to remake itself faster than it had planned.
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