27 June 2008

KG: Look Ahead to June 2008 Results

We previously analyzed King Pharmaceuticals preliminary financial statements for 2008's first quarter, but we overlooked, until recently, the more complete 10-Q report for this period. The additional data in the 10-Q bumped up our Overall Gauge score to an outstanding (but misleading, see below) 74 points. Our initial estimate had been 69 of the 100 possible points.

King Pharmaceuticals, Inc. (KG) sells various brand-name prescription pharmaceutical products. The company experienced a substantial setback last year when the U.S. Court of Appeals invalidated King's patent for Altace® (Ramipril). This ACE inhibitor, used to treat patients with cardiovascular risks, had accounted for roughly 1/3 of King's net sales. As a result of the Court's action, King incurred asset impairment charges (covering intangible assets and inventory) totaling $250 million.

The situation with King illustrates a substantial limitation of the GCFR methodology: misleading scores are a risk when the subject company's business model changes materially and abruptly. The potential for error increases as the historical data that drives the scores becomes less relevant.

The Altace patent invalidation qualifies as a major change for King, and the company's shares dropped immediately on this news. At about $10 each now, King shares sell for less than 1/2 of their 52-week high and less than 1/4 of their all-time high. However, it will take time for the full effects of the patent invalidation to be reflected in the company's earnings and cash flow. (King, as explained on the Orange Book Blog, tried unsuccessfully to delay the availability of generic ramipril from sources other than Cobalt Laboratories.) This situation -- a bargain-basement share price and still-respectable earnings -- makes King look like an exceptional value to our number-crunching gauges.

On 7 August 2008, King is scheduled to announce its results for the nearly concluded second quarter. In anticipation of this report, we've modeled the company's Income Statement for the quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

This guidance was updated during King's conference call with financial analysts in May 2008.

Management's only guidance with respect to Revenue was to note that Altace sales will "significantly decrease" during the rest of 2008. In the first quarter, Revenue was 16 percent below that in the year-earlier period. With this as our only guide, we have assumed that Revenue in the current quarter will be 25 percent less than the June 2007's $543 million. This would be $407 million.

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 slip to approximately 75 percent of Revenue in 2008. If we apply this ratio to our second quarter Revenue estimate, Cost of Goods Sold (CGS) would be (1 - 0.75) * $407 million = $102 million.

The company was very clear that it expects quarterly expenses for Depreciation and Amortization to be about $31 million. This figure is 7.6 percent of our Revenue estimate, which is consistent with historical results.

The company indicated that Research and Development expenses in 2008 will grow to about $180 million, from nearly $150 million in 2007. If we subtract the first quarter's $29 million from the expected total for the year, and split the result evenly over the three remaining quarters, we get an R&D estimate for the quarter of $50 million. This is 12.3 percent of our Revenue estimate, which is much higher than 7 percent ratio more typical at King.

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 subtract $75 million from this figure, then subtract the first quarter's $130 million, and divide by three, we get an $165 million SG&A estimate for the second and subsequent quarters 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 last 10 quarters, the average charge was about $70 million. However, we're going to assume no special charges in the second quarter.

The estimates above would lead to an Operating Income for the quarter of $59 million, compared to $88 million in the June 2007 quarter.

Net Non-Operating Income or Expense has been about $10 million in the last few quarters.

If the Income Tax Rate matches the first quarter's 34 percent, Net Income would be $46 million ($0.19 per share). This figure was $65 million ($0.27 per share) in June 2007.

Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

($ M)

June 2008
June 2007

Op expenses

CGS (102)


R&D (50)

SG&A (165) (173)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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