20 April 2008

KG: Look Ahead to 2008 First Quarter Results

Our last report on King Pharmaceuticals analyzed the company's 10-K annual report for 2007. The report vividly exemplified a substantial limitation of the GCFR methodology: by focusing on past performance, viewed only in quantitative terms, our approach can produce misleading results when the subject company's business model changes materially and abruptly.

We've experienced this problem when the corporations we're evaluating undertake, or become the targets of, significant mergers or acquisitions. However, in the case of King Pharmaceuticals, Inc. (KG), a maker of brand-name prescription drugs, the business change was a decision by the U.S. Court of Appeals on 11 September 2007 to invalidate King's patent for Altace®. This product is an ACE inhibitor used to treat patients with cardiovascular risks. It had accounted for roughly 1/3 of King's net sales.

King's difficulties are magnified because the company is also facing the loss of patent protection on other key products. In a seemingly unrelated manner, 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.

KG shares, which had already been declining in price, dropped further when the court ruling became public. The shares currently sell for about 40 percent of their 52-week high and less than 1/5 of their all-time high. As a result of the Altace® decision, King recorded asset impairment charges (covering intangible assets and inventory) totaling $250 million. However, it will take time for the full effects of the patent invalidation to be reflected in the company's earnings and cash flow. This situation -- a bargain-basement share price and still-respectable earnings -- makes King look like a good value to our number-crunching gauges. The Overall gauge score was a very good 69, out of 100 possible, points when we analyzed 2007's fourth-quarter results.

We've now made an estimate of King's results in the quarter that ended in March 2008. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data, which the company will publish on 8 May 2008. Our estimates are derived from trends in the company's historical financial results and from statements made by company management when they conducted a conference call with financial analysts.

As is typically the case for King, management did not provide any guidance regarding first-quarter Revenue. This is a figure very hard for us to estimate given the changes King is undergoing. 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. If the rate falls further to 5 percent, first-quarter Revenue would be about $500 million. [All references to year-over-year rates in GCFR are trailing four quarters compared to the four previous quarters. There are other definitions for the year-over-year term.]

King's Gross Margin had once been a Microsoftian 80 percent, or nearly so. High margins such as this are not unusual for specialty drug manufacturers. Management indicated that the margin would degrade, if that's the right word, to approximately 75 percent of Revenue in 2008. If we apply this figure to our first quarter Revenue estimate, the result would be a Cost of Goods Sold (CGS) of 25 percent of $500 million, or $125 million.

Expenses for Depreciation and Amortization had between 7 and 8 percent of Revenue until these expenses spiked upward at the end of 2007, which was probably due to a shortening of the predicted life of intangible assets. If we assume the increase was the result of one-time actions, and apply a 7.5 percent of Revenue charge to the first-quarter Revenue estimate, our target for Depreciation expense is 0.075 * $500 million, or$38 million.

The company indicated that Research and Development expenses in 2008 will grow to about $180 million, from nearly $150 million in 2007. Although we expect the increase to come in phases, it is sufficient for our purposes to expect 25 percent of the full-year R&D budget, or $45 million, in the first quarter.

King stated that Sales, General, and Administrative expenses would drop in 2008 by $75 to $90 million as a result of restructuring decisions. We assume this refers to a smaller sales force and a lower marketing budget. SG&A was about $700 million in 2007. If we slice $75 million from this figure, and divide by four, we get an $153 million SG&A estimate for each quarter of 2008.

King often takes special, purportedly non-recurring, operating charges that can determine whether quarterly earnings meet expectations -- for analysts that track GAAP earnings, not the "ex-items" figures that get so much attention. 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. Our assumption is that King's special charges were so substantial last year that figure will come down to $50 million in the first quarter of 2008. This does, however, complicate comparisons with the March 2007 quarter, which happened to be a rare period without these extra expenses.

The estimates above would lead to an Operating Income for the quarter of $90 million, compared to $168 million in the March 2007 quarter.

Net Non-Operating Income or Expense is typically less than $10 million. Our estimate for the quarter is income of $7 million. If the Income Tax Rate is 34 percent, per company guidance, Net Income would be $64 million ($0.26 per share). This figure was $116 million ($0.48 per share) in March 2007.

The average EPS estimate of the professional analysts tracked in Yahoo Finance is $0.34, much more than our figure. These analysts must have a better understanding of the pharmaceutical business than we do, but readers are cautioned that it is not known what, if any, items the analysts excluded from their estimates. For example, if we exclude $50 million for special operating charges, our EPS estimate would turn out to be $0.40.

($ M)

March 2008
March 2007

Op expenses

CGS (125)


R&D (45)

SG&A (153) (168)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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