King Pharmaceuticals, Inc. (KG) sells various brand-name prescription pharmaceutical products. Below $10 now, King shares sell for less than 1/2 of their 52-week high and less than 1/4 of their all-time high. The company experienced a substantial setback last year when 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. As a result of the Court's action, King incurred asset impairment charges (covering intangible assets and inventory) totaling $250 million.
Generic versions of Altace are now available. This situation, along with the potential loss of patent protection on other key products, led King to speed up a shift in the company's marketing focus towards neuroscience, hospital and acute care products and to layoff 20 percent of staff.
Reuters recently reported that the FDA warned King "that promotional material for its pain drug Avinza fails to warn consumers about the potential for abuse" and "made unproven claims about how well it worked." The generic name for Avinza is morphine sulfate.
When we analyzed King after 2007's fourth quarter results became available, the Overall Gauge score was 69, on a scale of 0 to 100. This robust score highlighted a substantial limitation of the GCFRmethodology: by focusing on past performance, the approach will produce misleading results when the business of the company being analyzed changes fundamentally and abruptly. The Altace decision constituted such as change. The price of King shares has already plunged, but company earnings reported to date haven't suffered the likely full effects of the patent invalidation. This situation -- a much diminished share price and still-respectable earnings -- increases the attractiveness of King to our number-crunching gauges.
With the data from the March 2008 quarter, our gauges are displaying the following scores:
- Cash Management: 18 of 25 (unchanged from December)
- Growth: 3 of 25 (down from 9)
- Profitability: 14 of 25 (up from 11)
- Value: 23 of 25 (down from 24)
- Overall: 69 of 100 (unchanged)
Before we examine the factors that affected each gauge, let's review the latest quarterly Income Statement and compare it to our previously communicated expectations.
Please note that the tabular 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) | | March 2008 (actual) | March 2008 (predicted) | March 2007 (actual) |
| Revenue (1) | | 432 | 500 | 516 |
| Operating expenses | | | | |
| | CGS (2) | (91) | (125) | (111) |
| Depreciation (3) | (60) | (38) | (36) | |
| | R&D | (29) | (45) | (32) |
| | SG&A (4) | (130) | (153) | (168) |
| Other (5) | (1) | (50) | (0) | |
| Operating Income | | 121 | 90 | 168 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | 11 | 7 | 7 |
| Pretax income | | 133 | 97 | 175 |
| Income tax | | (45) | (33) | (58) |
| Net Income | | 88 | 64 | 116 |
| | | $0.36/sh | $0.26/sh | $0.48/sh |
| Shares outstanding | | 245 | 245 | 244 |
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, plus Excess inventory reserve, plus Arbitration settlement, plus In-process R&D, Asset impairment charges, plus Restructuring charges.
Revenue in the recent quarter was 16.3 percent below that in the year-earlier period. We had expected Revenue to decline by 3.1 percent. This was the first quarter in which King faced generic competition for Altace, and it took a far bigger bite out of sales than we expected. Revenue in the trailing four quarters was 1.6 percent greater than in the previous four quarters, which fell below our prediction of a year-over-year Revenue growth rate of 5.0 percent.
We had thought, based on company-provided guidance, that King would achieve a 75 percent Gross Margin in the quarter. The actual margin was a remarkable (and more profitable 78.8) percent. This latter value translates into a Cost of Goods Sold (CGS) of 21.2 percent of Revenue.
Depreciation expenses were 13.8 percent of Revenue in the quarter, compared to our expectation of 7.5 percent. We mistakenly thought that the high Depreciation rate in the December 2007 quarter was the result of one-time events.
On the other hand, Research and Development (R&D) expenses were 6.6 percent of Revenue, well below our 9.0 percent prediction. We were closer to the target with Sales, General, and Administrative (SG&A) expenses, which were 30.1 percent of Revenue, instead of our 30.6 percent estimate.
Special operating expenses were only $1 million, dramatically less that our $50 million estimate. (In the 12 quarters of 2005 to 2007, seven of the quarters had charges greater than $75 million. The average charge per quarter was $81 million.) This enabled King's Operating Income to surpass our forecast by 34 percent, even though Revenue was much, much lower and Depreciation was substantially higher than we expected.
Interest income was $4 million more than forecast. The income tax rate was 33.9 percent, essentially matching the guidance.
Net Income was 24.5 percent less than in the March 2007 quarter, but 37.5 percent more than our prediction.
Cash Management. This gauge remained unchanged from 18 points in December.
| March 2008 | 3 months ago | 12 months ago | |
| Current Ratio | 5.0 | 4.0 | 3.0 |
| LTD/Equity | 15.5% | 15.9% | 16.6% |
| Debt/CFO | 0.6 yrs | 0.6 yrs | 0.7 yrs |
| Inventory/CGS | 111 days | 109 days | 177 days |
| Finished Goods/Inventory | N/A | 55.6% | 35.4% |
| Days of Sales Outstanding (DSO) | 40.0 days | 38.4 days | 48.0 days |
| Working Capital/Market Capitalization | 58.6% | 47.1% | 18.0% |
| Cash Conversion Cycle Time | 96.9 days | 83.7 days | 166.9 days |
King has huge amount of Cash on their Balance Sheet. They could be refinancing debt, preparing to meet upcoming expense, or, perhaps, getting ready to make a large investment. The level of Working Capital as a percentage of Capitalization is very high.
Growth. This gauge decreased from 9 points in December to 3 points now.
| March 2008 | 3 months ago | 12 months ago | |
| Revenue growth | 1.6% | 7.5% | 7.0% |
| Revenue/Assets | 60.0% | 62% | 61% |
| CFO growth | 12.6% | 44.5% | 18.1% |
| Net Income growth | -56.2% | -36.5% | 253% |
Growth has obviously decelerated.
Profitability. This gauge increased from 11 points in December to 14 points now.
| March 2008 | 3 months ago | 12 months ago | |
| Operating Expenses/Revenue | 74.3% | 72.9% | 69.3% |
| ROIC | 18.3% | 14.6% | 15.2% |
| FCF/Equity | 23.2% | 24.8% | 22.0% |
| Accrual Ratio | 9.0% | 8.4% | 13.4% |
With the exception of the increasing Operating Expenses, the Profitability figures have improved in the last year.
Value. King's stock price dropped over the course of the quarter from $10.24 to $8.70, which kept the Value gauge from dropping more than 1 point, from 24 to 23.
| March 2008 | 3 months ago | 12 months ago | |
| P/E | 13.8 | 13.6 | 13.5 |
| P/E to S&P 500 average P/E | 82.9% | 77% | 85% |
| Price/Revenue | 1.0 | 1.2 | 2.4 |
| Enterprise Value/Cash Flow (EV/CFO) | 1.7 | 2.3 | 7.6 |
Under other circumstances, we would view an Overall Gauge score of 69 out of 100 possible points as a strong indication that a company is performing well and has an undervalued stock price. However, King Pharmaceuticals' future is going to be very different from its past. Time will tell whether they can replenish their product pipeline fast enough to compensate for patent expirations.
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