King Pharmaceuticals, Inc. (NYSE: KG) manufactures and sells various brand-name prescription pharmaceuticals. Headquartered in Bristol, TN, King now focuses on specialty products for the neuroscience, hospital and acute care markets.
In 2007, the U.S. Court of Appeals invalidated King's patent for Altace® (Ramipril). This ACE inhibitor, used to treat patients with cardiovascular risks, had accounted for roughly 1/3 of King's net sales. The Court's decision resulted in King recognizing asset impairment charges (covering intangible assets and inventory) totaling $250 million and King laying off 20 percent of its staff.
King recently approached Alpharma, Inc. (NYSE: ALO) shareholders with a sweetened $1.55 billion acquisition offer. This bid, which has been rejected by Alpharma's management, answered the question of what King planned for its $1 billion cash hoard. King's interest in Alpharma was probably piqued by the latter's KADIAN and FLECTOR products for treating acute pain. King and Pain Therapeutics, Inc. (NASDAQ: PTIE) recently presented test results for a promising chronic-pain treatment known as REMOXY.
At less than $10 each, the current price of King Pharmaceuticals common shares is approximately 80 percent below the all-time high set in 2001.
Three months ago, when generic Ramipril became available from firms other than Cobalt Laboratories, our analysis of King's second-quarter results lowered the Overall Gauge score by 20 points. The scores had been unrealistically high because the steep share price decline occurred well before King's sales contracted.
Now, with the data from the September quarter, our gauges are displaying the following scores:
- Cash Management: 13 of 25 (down from 17 in June)
- Growth: 8 of 25 (up from 4)
- Profitability: 16 of 25 (down from 17)
- Value: 22 of 25 (up from 11)
- Overall: 68 of 100 (up from 54)
Before we examine the factors that affected each gauge, we will review the latest quarterly Income Statement and compare it to our previously communicated expectations.
Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($ M) | September 2008 (actual) | September 2008 (predicted) | September 2007 (actual) | |
| Revenue (1) | 388 | 381 | 545 | |
| Op expenses | ||||
| CGS (2) | (101) | (95) | (198) | |
| Depreciation (3) | (30) | (31) | (37) | |
| R&D | (34) | (51) | (35) | |
| SG&A (4) | (99) | (111) | (185) | |
| Other | (1) | (23) | (168) | |
| Operating Income | 123 | 70 | (78) | |
| Other income | ||||
| Investments | 0 | 0 | (10) | |
| Interest, etc. | 5 | 10 | 8 | |
| Pretax income | 128 | 80 | (80) | |
| Income tax | (44) | (27) | (40) | |
| Net Income | 85 | 53 | (41) | |
| $0.34/sh | $0.22/sh | ($0.17)/sh | ||
| Shares outstanding | 246 | 245 | 243 |
2. Cost of revenues, exclusive of depreciation, amortization and some impairments.
3. Depreciation and amortization, plus accelerated depreciation.
4. SG&A, plus special legal and professional fees, plus co-promotion fees.
Revenue in the recent quarter was 28.7 percent below that in the year-earlier period, but it beat our estimate by 1.8 percent. We had expected Revenue to decline by 30 percent. About 80 percent of the Revenue decline is due to reduced Altace sales.
The Cost of Goods Sold (CGS) in the quarter was 26.1 percent of Revenue, which translates into a Gross Margin of 73.9 percent. Our target for the margin, based on company-provided guidance, was 75 percent.
Depreciation expenses, at 7.6 percent of Revenue, were consistent with guidance and our expectations.
Research and Development expenses were 8.7 percent of Revenue, and they were a substantial $17 million less than anticipated. Our target was based on management's guidance that R&D expenses in 2008 would be about $180 million. Through the first nine months of the year, R&D expenses have totaled only $111 million.
Sales, General, and Administrative (SG&A) expenses were 25.6 percent of Revenue. Our target had been 29 percent. SG&A expenses were lower than our expectation mainly because King recorded an $8 million anticipated insurance recovery of legal fees in this line item. Roughly half of the drop in SG&A expenses from last year's level was due to greatly reduced Altace co-promotion expenses.
King often records asset impairment and restructuring charges that can determine whether quarterly earnings meet expectations. In the September 2008 quarter, these charges were negligible. In the last 10 quarters, the average charge has been over $50 million.
King's Operating Income, which accounts for total sales and all operating expenses, more than reversed the loss seen in the September 2007 quarter. In addition, Operating Income surpassed our forecast by more than 76 percent. Our estimate proved too conservative because R&D, SG&A, and "special" expenses were all much less than we expected.
Interest income was $5 million less than forecast. The income tax rate was 33.9 percent, nearly equaling the 34.0 percent guidance.
For the reasons outlined above, Net Income was 60 percent more than our projection.
| Cash Management | September 2008 | 3 months ago | 12 months ago |
| Current Ratio | 5.3 | 4.4 | 3.7 |
| LTD/Equity | 14.6% | 15.2% | 16.3% |
| Debt/CFO | 0.7 yrs | 0.6 yrs | 0.7 yrs |
| Inventory/CGS | 109 days | 106 days | 112 days |
| Finished Goods/Inventory | 64.4% | 63.8% | 42.7% |
| Days of Sales Outstanding (DSO) | 45.2 days | 41.2 days | 44.9 days |
| Working Capital/Market Capitalization | 50.2% | 41.8% | 37.0% |
| Cash Conversion Cycle Time | 86.9 days | 88.2 days | 106.5 days |
| Gauge Score (0 to 25) | 13 | 17 | 22 |
On 30 September, King had over $1.2 billion in Cash or equivalents, which is far more than needed to meet current obligations. This war chest demonstrates King's seriousness in its $1.55 billion acquisition offer for Alpharma (NYSE: ALO).
King would have difficulty liquidating its investments in auction rate securities, with a total par value of $438.3 million.
These factors explain why the Current Ratio and Working Capital-to-Market Capitalization ratios are extremely high.
Debt, Inventory, and Days of Sales outstanding are all stable. The lower Cash Conversion Cycle Time shows improved cash management efficiency . The large proportion of Finished Goods in the Inventory is troubling, as it could be an indicator of slower than anticipated sales.
| Growth | September 2008 | 3 months ago | 12 months ago |
| Revenue growth | -17.3% | -7.6% | 11.5% |
| Revenue/Assets | 50.8% | 55.8% | 63.9% |
| CFO growth | 0.0% | 20.1% | 44.5% |
| Net Income growth | 45.5% | -56.8% | 12.8% |
| Gauge Score (0 to 25) | 8 | 4 | 16 |
With rapidly declining sales and decelerated Cash Flow, Growth isn't a big part of the current landscape at King. However, the increase in Net Income in the last four quarters is very encouraging.
| Profitability | September 2008 | 3 months ago | 12 months ago |
| Operating Expenses/Revenue | 71.3% | 75.4% | 73.6% |
| ROIC | 18.3% | 18.9% | 23.4% |
| FCF/Equity | 20.7% | 23.2% | 23.1% |
| Accrual Ratio | -27.1% | -26.3% | 8.8% |
| Gauge Score (0 to 25) | 16 | 17 | 11 |
The loss of Altace exclusivity has, to no one's surprise, trimmed King's operating margin. Nevertheless, the ROIC and FCF/Equity values remain quite appealing. The oddly low Accrual Ratio, which suggests high earnings quality, is a result of non-Cash charges to Net Income.
| Value | September 2008 | 3 months ago | 12 months ago |
| P/E | 9.1 | 19.3 | 16.1 |
| P/E to S&P 500 average P/E | 54.2% | 105.1% | 93.9% |
| Price/Revenue | 1.3 | 1.3 | 1.3 |
| Enterprise Value/Cash Flow (EV/CFO) | 2.4 | 2.7 | 3.6 |
| Gauge Score (0 to 25) | 22 | 11 | 22 |
King's stock price fell over the course of the quarter from $10.47 to $9.58. The valuation ratios above, which seem quite low, can be compared with other Drug Manufacturers.
The Cash Flow ratio should attract the attention of value investors.
| Overall | September 2008 | 3 months ago | 12 months ago |
| Gauge Score (0 to 100) | 68 | 54 | 73 |
We acknowledged that our rearward-looking gauges were painting a too rosy view of King Pharmaceuticals during the initial period after the Altace decision. Now that the Overall Gauge score has dropped and rebounded, we have more confidence in the optimistic results. King was more successful at cutting its expenses than we had hoped, it turned a profit under challenging circumstances, it is well capitalized, and the valuation metrics are appealing.
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