10 November 2007

KG: Financial Analysis through September 2007

We have analyzed King Pharmaceuticals' (KG) financial statements for the quarter that ended on 30 September 2007. The 10-Q filing with the SEC came just a day after the preliminary results were issued in a press release. We were pleased to see the 10-Q because the added detail helped us better understand how King is dealing with a major change to their business.

King Pharmaceuticals sells brand-name prescription pharmaceuticals. King suffered a major blow this September when a U.S. Court of Appeals invalidated a patent covering Altace® (a registered trademark of King Pharmaceuticals). This ACE inhibitor, which is used to treat patients with cardiovascular risks, had accounted for about 1/3 of King's net sales. A decline in the price of KG shares, which had started during the summer, accelerated when the news of the ruling became public. At about $11 each, KG shares now sell for less than 1/2 of their 52-week high and less than 1/4 of its all-time high.

The court ruling led King to record pre-tax charges, primarily related to Altace® asset impairment, of a massive $264 million. It also led King to accelerate a strategic plan to increase the company's focus on certain specialty pharmaceutical markets. This corporate restructuring includes a layoff 20 percent of staff.

The patent invalidation is just the latest in a long series of ills afflicting King. There have been Medicaid overcharge allegations, inventory management challenges, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections. Just the other day, the SEC closed a long-running investigation into whether King underpaid rebates owed the Government. King is still facing the looming loss of patent protection on key products other than Altace®.

When we analyzed King after the June quarter, the Overall gauge was 52 points, a good score. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 14 points. Growth and Value were weakest at 12 points each.

Now, with the available data from the September 2007 quarter, our gauges display the following scores:
Whoa! 78 points is an outstanding score. How can a company that has suffered such a great setback rate a top-notch score? The short answer is that the GCFR approach focuses on past results and trends. King is, however, at an inflection point where the future, given the sudden and dramatic loss of the Altace® business, will probably look very different from the past. King stock would be a bargain if we knew the company would continue to rake in profits as before; we have no reason to believe this will be the case.

Before we examine the factors that affected each gauge, let's review the latest quarterly Income Statement. Given the uncertain state of how the Altace® decision would affect King's finances, we did not issue a pre-release earnings prediction for September quarter.

($ M)
September 2007
September 2006
Revenue (1)
545 492
Op expenses

CGS (2) (198) (106)

Depreciation (37) (38)

R&D (35) (38)

SG&A (3) (185) (158)

Other (4) (168) (28)
Operating Income
(78) 123
Other income

Investments (10) 0

Interest, etc. 8
Pretax income
(80) 130
Income tax
40 (40)
Net Income
(41) 90

($0.17)/sh 0.37/sh

1. Net sales plus royalty revenue
2. Cost of revenues, exclusive of depreciation, amortization and some impairments.

3. SG&A plus co-promotion fees.
4. $148 million asset impairment charges; the rest is mostly restructuring charges

King's Revenue in the recent quarter was 10.8 percent greater than in the year-earlier period. The Cost of Goods Sold (CGS) was 36.3 percent of Revenue, compared to 21.7 percent in September 2006 and a five-year median value of 25 percent. CGS soared because it includes $82 million of impairment charges associated with Altace® inventory. CGS drops to 21.3 percent of Revenue in the recent quarter if the impairment charge is excluded.

Depreciation expenses were 6.7 percent of Revenue, down from the year-earlier value of 7.7 percent. Research and Development (R&D) expenses were 6.4 percent of Revenue, compared to 7.8 percent in September 2006. Sales, General, and Administrative (SG&A) expenses were 34 percent of Revenue; SG&A was 32.1 percent of Revenue one year ago.

Other operating expenses included $148 million in charges due to impaired Altace®-related intangible assets and $20 million restructuring charges.

As a result of the asset impairment and other special charges, Operating Income and Net Income both fell into negative territory.

If that wasn't bad enough, King also incurred a $10.5 million loss on an investment in Palatin Technologies, Inc. The investment was associated with a collaboration agreement that has since been terminated.

Cash Management. This gauge increased from 13 points in June to 22 points now.

All of these measures helped the gauge were:

Growth. This gauge increased from 12 points in June to 17 points now.

The measures that helped the gauge were:
Net income benefited from a change in the income tax rate from 32 to 26 percent.

The measures that hurt the gauge were:
  • Revenue growth = 11.5 percent year-over-year, down from 12.2 percent.

Profitability. This gauge increased from 14 points in June to 16 points now.

The measures that helped the gauge were:
  • FCF/Equity = 22.1 percent, up from 16.0 percent in a year
  • Accrual Ratio = -10.9 percent, down from -6.2 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 the inventory charges allocated to Costs of Goods Sold.

Value. King's stock price dropped precipitously over the course of the quarter from $20.46 to $11.72, which caused the Value gauge to soar to 22 points from 12 points three months ago.

All of these measures helped the gauge:

The average P/E for the Biotechnology and Drugs industry is an expensive 31. The average Price/Revenue for the industry is 8.5.

Under other circumstances, we would view an Overall Gauge score of 78 out of 100 possible points as a bright 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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