03 March 2007

KG: Analysis through December 2006

King Pharmaceuticals (KG) develops, manufactures, and sells branded, prescription pharmaceutical products. About 1/3 of King's net sales are due to Altace®, an ACE inhibitor, to treat patients with cardiovascular risks.

Over the last few years, KG has had its share of problems, including Medicaid overcharge allegations, hefty "intangible asset impairment charges" due to disappointing sales, inventory management challenges, financial restatements, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections. We first saw evidence in the second and third quarters of 2005 that King turned the corner. The scores shown on the Overall gauge were in the upper 70's at the conclusion of both of those two quarters, after having been in the 20's the three previous quarters. [The stock price on 30 June 2005 was $10.42, and it was around $17 most of 2006.] The scores then sagged through the first three quarters of 2006.

When we analyzed King after the quarter that ended in September 2006, the Overall score had dropped to a modest 39 points. Of the four individual gauges that fed into this overall result, Cash Management was the strongest at 17 points. Value was weakest at 7 points.

We have since updated the analysis to incorporate King's 10-K results for the full year and fourth quarter. With the data available through 31 December 2006, our gauges now display the following scores:

Cash Management. This gauge held steady at 17 points. The Current Ratio is now 2.7 It has been at this solid level for two quarters after having bottomed out at around 1.3. Long-Term Debt/Equity is an easily manageable 17 percent, down 1 percent the previous quarter. Inventory/Cost of Goods Sold is now 187 days. The inventory level was 179 days at the end of the prior quarter, and it was a warehouse-stuffing 252 days at the end of December 2005. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is 24 percent. This is much lower than the typical level for the company, and it suggests sales were greater than expectations. Accounts Receivable/Revenues are 49 days. It has been pretty steady at this level for the last couple of years, after having been much higher. There is no indication the company is finding it more difficult to get its customers to pay their bills.

Growth. This gauge dropped 2 points from September. Revenue growth is now 12 percent year over year, down from 36 percent a year ago when the company was rebounding from earlier problems. Net Income growth is an eye-opening 147 percent. The $171 million increase in Net Income, however, can be fully explained by a reduction in intangible asset impairment charges of $173 million (from $221 million to $48 million); a lower income tax rate (from 35 to 32 percent) also helped. Most notably, the Net Income increase was not due to improved profitability in the company's core operations (see below). Further evidence of this situation is that CFO growth was actually down 10 percent. Revenue/Assets is 60 percent; it has been steady for the last year after having been much lower. Since its problems a couple of years ago, King has becoming more efficient at generating sales.

Profitability. This gauge also dropped 2 points from the prior quarter. ROIC slipped to a moderate 15 percent. It was 18 percent a year ago. FCF/Equity fell to 18 percent from 24 percent. Operating Expenses/Revenue moved up in the last year from 66 percent to 72 percent. The change was primarily due to a decline in Gross Margin and increase in R&D expenses. Even here, we have to dig deeper: a $45 million arbitration charge was assigned to SG&A expenses and acquisition-related R&D expenses were substantial. The Accrual Ratio, which we like to be both negative and declining, went the wrong direction by soaring to -4 percent from -12 percent. This tells us that much less of the company's Net Income is due to CFO, and, therefore, more is due to changes in balance sheet accruals.

Value. This gauge, based on the stock price of $15.92 at year's end jumped remarkably to a strong 20 points, compared to 7 points and only 1 point three and twelve months ago, respectively. (The increase sure got the pulse rate up when we calculated the new reading of the Value gauge. We now understand that non-recurring gains and losses drove the result more than anything else.) The P/E at the end of the quarter was 13.4, down substantially from recent quarters. The decrease suggests the shares have become less expensive. The average P/E for the industry is a much more expensive 32. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 17 discount to the average P/E, using core operating earnings) for stocks in the S&P 500. Historically, the company's price has been at a substantial premium to the market, as expressed by this measure. Companies tend to trade at a premium when their growth rates are greater than average, particularly when the growth rates seem more likely to be sustained. The PEG ratio of .09 is indicative of a bargain stock. The Price/Revenue ratio, which isn't affected by the one-time factors that cause wide swings in earnings, has declined to 190 percent from the 215-230 percent range. This decrease also suggest the shares have become less expensive. The average Price/Sales for the industry is a rather astounding 875 percent.

Having jumped to a very good 60 out of 100 possible points, the Overall gauge would appear to reflect, or even signal, a substantial increase in King's fortunes. However, of the four component gauges, only the highly weighted Value gauge actually increased. This increase was due, in large part, to the massive and seemingly wonderful 147 percent increase in Net Income. However, the analysis revealed that a reduced intangible asset impairment charge drove the earnings increase more than anything else. The drop in operational profitability might not be as bad as first appears because of non-recurring factors, but, when coupled, with the big drop in CFO, we see a red flag. We want to see how the gauges change in the next couple of quarters to figure out what is actually happening.

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