19 August 2007

KG: Financial Analysis through June 2007 (Updated)

The preliminary financial results reported by King Pharmaceuticals' (KG) for the quarter that ended on 30 June 2007 did not include complete inventory and cash flow data. For the analysis we reported previously, we had to make certain estimates. The 10-Q report subsequently filed by the company with the SEC included the missing data, and we have updated our analysis accordingly.

The net effect of the additional information was to increase Free Cash Flow (FCF) by about $6 million for the quarter to $138 million.

The 10-Q also restated King's Balance Sheet for December 2006 to reflect the recent sale of the company's manufacturing operations in Rochester, Michigan.

For completeness, our entire analysis is provided below. It repeats information from the earlier analysis.


King Pharmaceuticals sells brand-name prescription pharmaceuticals, most notably Altace®. This ACE inhibitor, which is used to treat patients with cardiovascular risks, accounts for about 1/3 of King's net sales.

King experienced some difficulties in the early years of this decade, including Medicaid overcharge allegations, inventory management challenges, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections. King stock plunged 84 percent from $46.05 per share in July 2001 to $7.55 in April 2005, before rebounding to about $20. King has dealt with these problems. But, it now faces a challenge that could be more difficult to surmount: the looming loss of patent protection on Altace and other key products.

When we analyzed King after the March quarter, the Overall score was an excellent 59 points. Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 19 points. Profitability and Value were weakest at 13 points each. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the June 2007 quarter, our gauges display the following scores:

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.


($ M)
June 2007
(actual) 		June 2007
(predicted)
 June 2006
(actual)
Revenue
543
 535
 500
Op expenses




CGS (1) (126)
 (123)
 (107)

Depreciation (2)
 (40)
 (37)
 (39)

R&D (37)
 (37)
 (35)

SG&A (3) (173)
 (187) (154)

Other (4)
 (78)
 (20)
 (0)
Operating Income
88
 130
 165
Other income




Investments
 0
 0
 0

Interest, etc.
 7
 7
 5
Pretax income
95
 137
 170
Income tax
(30)
 (45)
 (59)
Net Income
65
 92
 111


$0.27/sh
 0.37/sh
 0.46/sh





1. Includes contract termination cost of $3.845 million.
2. Includes $1.5 million for "accelerated depreciation"
3. Includes co-promotion, legal, and professional fees.
4. Mostly asset impairment charges; also in-process R&D upon acquisition, restructuring charges


Revenue was 1.5 percent above our estimate. We expected Revenue to be 7 percent greater than in the year-earlier quarter, and the actual increase was 8.6 percent. In addition, we thought the Cost of Goods Sold (CGS) would be 23 percent of Revenue, and the actual value was 23.2 percent.

Depreciation was 7.4 percent of Revenue, compared to our estimate of 7 percent. Research and Development (R&D) expenses were 6.8 percent of Revenue, a shade less than our 7 percent estimate. Sales, General, and Administrative (SG&A) expenses were 31.9 percent of Revenue, compared to our forecast of 35 percent.

What threw the quarter out of kilter was a $74.8 million asset impairment charge. The charge resulted from a decision to sell a manufacturing plant and to drop development of a new product formulation.

The net effect was Operating Income 32 percent below the forecast value.

The Income Tax Rate was 31.6 percent, instead of the predicted 33 percent. As a result, Net Income fell below our prediction by 29 percent.


Cash Management. This gauge decreased from 19 points in March to 17 points now.

The measures that helped the gauge were:
The measures that hurt the gauge were:

Growth. This gauge decreased from 16 points in March to 12 points now.

The measures that helped the gauge were:
Net income benefited from a change in the income tax rate from 34.7 to 31.4 percent.

The measures that hurt the gauge were:

Profitability. This gauge increased from 13 points in March to 14 points now.

The measures that helped the gauge were:
  • FCF/Equity = 20.1 percent, up from 14.9 percent in a year
  • Accrual Ratio = -5.8 percent, down from -4.1 percent in a year
  • ROIC = 13.9 percent, down from 16.5 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:
The increase in operating expenses was the result of a decrease in Gross Margin and an increase in special charges.


Value. King's stock price rose over the course of the quarter from $19.67 to $20.46. The Value gauge, based on the latter price, decreased to 12 points from 13 points three months ago.

The measures that helped the gauge were:
  • P/E = 16.3, about half its median value
  • P/E to S&P 500 average P/E = 2 percent discount, much lower than its five-year median of a 60 percent premium
The measures that hurt the gauge were:

The average P/E for the Biotechnology and Drugs industry is 28. The average Price/Revenue for the industry is 8.


Now at 52 out of 100 possible points, the Overall gauge has been strong for eight of the last nine quarters. To some extent, the strength reflects a rebound from very tough conditions in previous years. We would feel much better about King if special operating charges weren't such a regular occurrence. We also have to worry now about patent expirations.
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