12 May 2007

KG: Financial Analysis through March 2007

King Pharmaceuticals (KG), a manufacturer of branded, prescription pharmaceutical products, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. This post reports on our analysis of those results.

About 1/3 of King's net sales are due to Altace®, an ACE inhibitor, which is used to treat patients with cardiovascular risks.

Over the last few years, KG has overcome a series 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.

When we analyzed King after the results from December 2006 became available, the Overall score was a very good 60 points. Of the four individual gauges that fed into this composite result, Value was the strongest at 20 points. Growth was weakest at 7 points. We noted that the good results could be attributed to lower intangible asset impairment charges, which, more than core operations, translated into a large increase in Net Income. Since Cash Flow from Operations actually dropped, we were not convinced that business at King was as healthy as the gauges suggested.

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

Cash Management. This gauge increased 2 points from 17 points in December. The Current Ratio is now 3.0, which is a sign of strength. We might have deemed the Current Ratio to be a little too high, except that it makes the recovery from a weak 1.3 in a mere 15 months even more impressive. Long-Term Debt/Equity is an easily manageable 17 percent. The debt ratio was also 17 percent in December, and it was 20 percent 12 months ago. Inventory/Cost of Goods Sold dropped to 173 days from 187 days three months ago and 226 days at the end of March 2006. The percentage of Inventory that is product ready for sale is 28 percent; the Finished Goods ratio has been averaging around 30 percent. Taken together, the two inventory ratios hint that sales were somewhat greater than expectations. Accounts Receivable are 48 days of Revenue, which improved on the 52-day level one year earlier. It might be indicating the company is finding it less difficult to get its customers to pay their bills.

Growth. This gauge increased a hefty 10 points from 7 points three months ago. Revenue growth, however, weakened to 7 percent year over year from 37 percent a year ago. Net Income growth is a jaw-dropping 253 percent, although down from a crazy 600 percent a year ago when the company was rebounding from earlier troubles. The increase in Net Income is not as excellent as first appears: it can fully be attributed to the elimination of the previous year's special charges, such as intangible asset impairment charges. CFO growth is a solid 18 percent, although also down from unsustainable levels in March 2006. Revenue/Assets is 61 percent. It has held steady at this level for the last year or so, after having been much lower. Since its problems a couple of years ago, King has becoming more efficient at generating sales.

Profitability. This gauge increased 2 points from the prior quarter's 10 points. ROIC, however, slipped to a still-good 14 percent from 19 percent a year ago. FCF/Equity held at a strong 22 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 an increase in R&D expenses. The Accrual Ratio, which we like to be both negative and declining, has the right sign, but it moved in the wrong direction from -10 percent to -5 percent. This tells us that less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.

Value. King's stock price rose over the course of the quarter from $15.92 to $19.67. The Value gauge, based on the latter price, dropped 1 point from 20 to 19 points over this period. The P/E at the end of the quarter was a modest and seemingly inexpensive 14. The average P/E for the Biotechnology and Drug Industry is a much more expensive 34. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 15 percent less than the average P/E, using core-operating earnings, of stocks in the S&P 500. Historically, the company's P/E has had a substantial premium to the market multiple. The current discount tells us that the market is expecting the company's earnings to grow slower than the average company. We consider the PEG ratio to be N/A because non-recurring factors have had such a significant effect on the earnings growth rate. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has increased to 2.4, which is much, much less than the average Price/Sales for the Biotechnology and Drug Industry of 9.

Now at a very good 65 out of 100 possible points, the Overall gauge would appear to reflect, or even signal, a substantial increase in King's fortunes. However, we suspect that our gauges are giving to much credit to the rebound that has already occurred and is unlikely to be sustained. With the low Valuation metrics, investors are certainly displaying their skepticism about future sales and earnings. Net Income would have declined in the recent four-quarter period if "special" charges had been excluded. The declining Gross Margin will have to be reversed for the good times to continue. This will be difficult to achieve with some of the company's most notable products approaching the end of the patent lifetimes. If King were to confound expectations and grow earnings at the healthy rate of other drug stocks, the upside potential in the stock would seem to be very high.

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