King Pharmaceuticals sells brand-name prescription pharmaceuticals. King suffered a major blow when the U.S. Court of Appeals decided on 11 September 2007 to invalidate King's patent for Altace®. In December 2007, the Court denied the company's petition for a rehearing. Altace® is an ACE inhibitor used to treat patients with cardiovascular risks. It had accounted for about 1/3 of King's net sales. As a result of the Court's decision, King's third quarter financial statements included asset impairment charges (covering intangible assets and inventory) totaling $250 million. It also led King to speed up a shift in the company's marketing focus and to layoff 20 percent of staff.
The patent invalidation decision accelerated a decline in the price of King's shares. Below $11 now, the shares sell for less than 1/2 of their 52-week high and less than 1/4 of their all-time high.
King is also facing the loss of patent protection on products other than Altace®.
When we analyzed King after the September quarter, the Overall Gauge ironically soared over 70 points (78 points at that time, 72 points after tweaks to our scoring algorithms). Why would our Gauges surge for a company facing such substantial challenges? The explanation is that we compared the company's historic results to a stock price that had been sliced in half. If the past was a true indication of the future, King shares would be at bargain basement levels. However, King without Altace® exclusivity isn't likely to match its historic results, and the share price is more indicative of the future than the past.
The central premise of GCFR is that historical financial data can help size up a company; however, the King example teaches us a lesson on the limitations of our approach.
Our gauges still haven't caught up with the new reality. With the data from the December 2007 quarter, we're still seeing scores that we consider to be overly bullish:
- Cash Management: 18 of 25
- Growth: 9 of 25
- Profitability: 11 of 25
- Value: 24 of 25
- Overall: 69 of 100
Before we examine the factors that affected each gauge, let's review the latest quarterly Income Statement and compare it to our expectations.
| ($ M) | | Dec 2007 (actual) | Dec 2007 (predicted) | Dec 2006 (actual) |
| Revenue (1) | | 533 | 524 | 513 |
| Op expenses | | | | |
| | CGS (2) | (109) | (126) | (114) |
| Depreciation (3) | (61) | (40) | (37) | |
| | R&D | (45) | (39) | (41) |
| | SG&A (4) | (164) | (173) | (187) |
| Other (5) | (104) | (50) | (93) | |
| Operating Income | | 49 | 96 | 42 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | 12 | 7 | 7 |
| Pretax income | | 61 | 103 | 49 |
| Income tax | | (18) | (32) | (12) |
| Net Income | | 43 | 71 | 37 |
| | | $0.18/sh | 0.29/sh | 0.15/sh |
| | |
1. Total revenues. Net Sales plus royalty revenues.
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.
5. Excess purchase commitment (2007), plus Excess inventory reserve (2007), plus Arbitration settlement (2006), plus In-process R&D (2007), Asset impairment charges, plus Restructuring charges (2007)
King's Revenue in the recent quarter was 4.0 percent greater than in the year-earlier period. The growth rate on a full year-over-year basis was 7.5 percent, beating our expectation of 7.0 percent.
The Cost of Goods Sold (CGS) in the quarter was 20.5 percent of Revenue, much lower than the 24.0 percent prediction. The difference can be explained by noting that we backed out a $21.6 million charge to CGS for "excess inventory reserve" and treated it as an "other" operating expense.
Depreciation expenses were an unprecedented 11.4 percent of Revenue in the quarter, compared to our expectation, based on company guidance, of 7.6 percent. The expense was higher because of product rights purchased and impairments associated with Altace.
Research and Development (R&D) expenses were 8.4 percent of Revenue, compared to our 7.5 percent expectation. Sales, General, and Administrative (SG&A) expenses were 30.8 percent of Revenue, much less than our 33 percent estimate.
The number of other operating expenses cut deeply into Operating Income, which was only about half what we expected.
Slightly higher interest income than forecast, and slightly lower income tax rate, softened the blow on Net Income, which was 39 percent less our prediction. However, Net Income exceeded its value during the year-earlier quarter by 16 percent.
Cash Management. This gauge decreased from 22 points in September to 18 points now.
All of these measures helped the gauge:
- LTD/Equity = 15.9 percent; relatively low and down from 17.5 percent at the end of 2006
- Inventory/CGS = 109.3 days; slashed, as a result of inventory write-downs, from 193 days last year.
- Cash Conversion Cycle Time (CCCT) = 83.7 days; cut by almost 50 percent in a year; the inventory write-off also creates an artificial appearance of improved efficiency
- Debt/CFO = 0.6 years, a trivial value and down from 0.9 years at the end of 2006
- Working Capital/Market Capitalization = 47.1 percent, an extremely high value that might interest an acquirer. This ratio was 24.7 percent one year ago.
- Days of Sales Outstanding (DSO) = 38.4 days, down from the 44.9 days one year earlier.
- Finished Goods/Inventory =55.6 percent; it was 30.6 last year. Impairment charges reduced other inventory components more than Finished goods.
- Current Ratio = 4.0; too much of a good thing, it was 2.7 in December 2006.
Growth. This gauge decreased from 17 points in September to 9 points now.
The measures that helped the gauge were:
- CFO growth = 44.5 percent year-over-year, up from -10.4 percent
- Revenue/Assets = 62.4 percent, up from 59.7 percent in a year.
- Net Income growth = -36.5 percent year-over-year, down from 147 percent
- Revenue growth = 11.5 percent year-over-year, down from 12.2 percent
Profitability. This gauge increased from 10 points in September to 11 points now.
The measures that helped the gauge were:
- FCF/Equity = 24.8 percent, up from 18.3 percent in a year
- ROIC = 14.6 percent, decent but down from last year's 16.1 percent
- Operating Expenses/Revenue = 72.9 percent, up from 69.4 percent in a year.
- Accrual Ratio = 8.4 percent, up from 7.8 percent in a year
As the result of a reader comment, we're experimenting with a different way to calculate the Accrual Ratio. We'll explain the details in a subsequent post, but the new approach provides a much less optimistic view of the relationship between King's Net Income and Cash Flow. Low Accrual Ratios, preferably below 0, indicate that more of the company's Net Income is due to Cash Flow and, therefore, less is due to changes in non-operational Balance Sheet accruals.
Value. King's stock price dropped over the course of the quarter from $11.72 to $10.24, which caused the Value gauge to soar to a breath-taking 24 points.
All of these measures helped the gauge:
- P/E = 13.6, well below its five-year median value of 26.4
- P/E to S&P 500 average P/E = a 20 percent discount, compared to a five-year median of a 60 percent premium
- Price/Revenue ratio = 1.2, much less than its median of 2.2
- Enterprise Value/Cash Flow = 2.3, less than half its median value of 8.1
The average P/E for the Biotechnology and Drugs industry is an expensive 27.5. The average Price/Revenue for the industry is 7.4.
Under other circumstances, we would view an Overall Gauge score of 69 out of 100 possible points as a 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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