24 December 2007

KG: Look Ahead to December 2007 Results

Our last evaluation of King Pharmaceuticals (KG) occurred not long after the decision by the U.S. Court of Appeals on 11 September 2007 to invalidate King's patent for Altace®. (The Court, in December, 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 accelerate a shift in the company's marketing focus and to layoff 20 percent of staff.

King stock, which had been declining before the ruling, fell further when the news became public. King shares now sell for less than 1/2 of their 52-week high and less than 1/4 of the all-time high.

The drop in the stock price to reflect the loss of expected future profits threw our evaluation methodology out of whack. Our Overall Gauge score for King perversely soared because it compared the diminished stock price to previous earnings and cash flow and saw a bargain. Clearly, however, King Pharmaceuticals' future earnings and cash flow will be much less without Altace® exclusivity.

Given the uncertainties, we're going to have to rely heavily on guidance from King to look ahead to the fourth-quarter results. Fortunately, the conference call with analysts after the third quarter included much useful guidance for the fourth quarter. Unfortunately, top-line Revenue guidance wasn't provided.

King's year-over-year Revenue growth rate has recently been fluctuating between 7 and 12 percent, which is a much slower pace than the company once enjoyed. Considering that it will probably take some time for competitors to take a serious bite out of Altace® sales, but also that the sales force might have lost some motivation, we'll assume Revenue in the fourth quarter will grow at a rate not less than the bottom of the recent range. Fourth-quarter Revenue of $524 million would translate into a 7 percent year-over-year growth rate.

King announced that it anticipates a Gross Margin of approximately 76 percent in the fourth quarter. High margins such as this, or even better, are not unusual for specialty drug manufacturers. This margin would result in a Cost of Goods Sold (CGS) of 24 percent of $524 million, or $126 million.

After shortening the predicted life of intangible assets associated with Altace®, King stated at the conference call that they now expect Depreciation and Amortization expense in the fourth quarter to be approximately $40 million.

The company indicated that its full year 2007 Research and Development (R&D) investment will be in line with last year. Given that R&D was $143.6 million in 2006, and $104.5 million in the first nine months of 2007, it's not hard to figure out that fourth quarter R&D should be about $39.1 million.

King gave guidance for Sales, General, and Administrative (SG&A) expenses in 2008 but not for the fourth quarter of 2007. Historical results would suggest that 33 percent of Revenue is good estimate for SG&A expenses. This would be $173 million if our Revenue estimate stands up.

King often takes special operating charges that determine the quarter's success. The charges range, in no particular pattern, between negligible and huge. We're going to assume, rather arbitrarily, a $50 million charge in the fourth quarter.

Our estimates would lead to Operating Income of $96 million.

Non-operating income has recently been about $7 million per quarter. If the Income Tax Rate (another fluctuating parameter) is 31 percent, Net Income would be $71 million.

($ M)

Dec 2007
Dec 2006

Op expenses

CGS (126)


R&D (39)

SG&A (173) (232)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income



  1. I got Accrual Ratio for King Pharmaceuticals Inc. (KG) +8% it's should not exceed 5%.

  2. We calculate Accrual Ratio with this equation:

    Accrual Ratio = (Net Income - Free Cash Flow) / (Total Assets)

    Our definition of Free Cash Flow is Cash Flow from Operations - Capital Spending.


    AR = (NI - CFO + CS) / TA

    During the four quarters ending on 30 September 2007, these values for KG are the following:

    NI = $177.5 million
    CFO = $595.4 million
    CS = $51.3 million
    TA = $3,378 million on 30 Sept 2007 (averaging the assets over the four quarters doesn't materially change the results.)

    AR = (177.5 - 595.3 + 51.3) / (3378)

    = -10.85 percent

    The are other ways to make the calculation, which could produce very different results. For example, we could limit NI, CFO, and CS to the most recent quarter, instead of the trailing four quarters.

    In this case,

    AR = (-40.5 - 174.3 + 18.6)/3378
    = -5.8 percent

    We don't use the single-quarter result because it is quite volatile and can, therefore, be misleading.

    One can also compute the Accrual Ratio with variations of Net Income that exclude certain gains and losses, mostly likely those that are non-recurring. We use the GAAP net income figure.

    We would be interested in learning how other analysts compute and evaluate accrual ratio.

  3. I calculated Accrual Ratio=(Net Income-(Cash from Operating Activities+Cash from Investing Activities))/Total Assets

    And I got +8%.

  4. Net Income/Starting Line:

    Cash from Operating Activities:

    Cash from Investing Activities:

    Total Assets:

  5. Thanks for the clarification. The values we listed apply to the period ending 30 Sept 2007 and the values you listed apply to the year ending 31 Dec 2006. This can be seen by looking at the 10-K report.

    The other difference, and it is quite significant, is that we consider only the Capital Spending (i.e., purchases of property, plant, and equipment) part of Cash from Investing, and you consider the full amount.

    Maybe your approach is better. It was cited here:

    We will have to dig into the files to see why we chose the approach we did.

    Thanks for pointing out the difference!