24 September 2008

KG: Look Ahead to September 2008 Quarterly Results

A year has elapsed since the U.S. Court of Appeals invalidated the patent for Altace® (Ramipril) held by King Pharmaceuticals, Inc. (NYSE: KG), a maker of brand-name prescription pharmaceutical products.  Altace®, an ACE inhibitor used to treat patients with cardiovascular risks, had accounted for roughly 1/3 of King's net sales.

King's share price dropped in the immediate aftermath of the Court's decision.  The company recognized asset impairment charges (covering intangible assets and inventory) totaling $250 million, announced plans to layoff 20 percent of staff, and the company sped up a shift towards neuroscience, hospital and acute care products.

The effects of the invalidation on the company's sales and profitability were slower to be felt.

Consistent with the strategic shift, King recently approached the shareholders of Alpharma, Inc. (NYSE: ALO) with a sweetened $1.5+ billion acquisition bid.  This offer, which has been rejected by Alpharma's management, answered the question of what King planned for its $1 billion cash hoard.  King's interest in Alpharma was probably piqued by the latter's KADIAN and FLECTOR products for treating acute pain.  King and Pain Therapeutics, Inc. (NASDAQ: PTIE) recently presented test results for a budding chronic-pain treatment known as REMOXY.

When trading in King call options surged in early August, Bloomberg reported on speculative rumors that King itself could be an acquisition target of Pfizer Inc. (NYSE: PFE).

During the first few quarters after the Altace decision, before its negative consequences really took hold, the GCFR gauges of King's performance went haywire and misleadingly indicated that King shares were significantly undervalued.  It was during this period that the Overall gauge soared to 75 points, normally a superlative score.  It took until the second quarter of 2008, when generic Ramipril became available from firms other than Cobalt Laboratories, for our gauges to move towards a more realistic assessment of King.  The Overall gauge fell 20 points when we analyzed King's June 2008 quarterly results.

On 6 November 2008, King is scheduled to announce its results for the nearly concluded third 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.

Readers are advised to read the transcript (at SeekingAlpha.com) from King's conference call with financial analysts on 7 August 2008.  The conference call in May 2008 had more content related to earnings guidance.

Based on the results from the second quarter, we expect Revenue in the September 2008 quarter to be 30 percent less than in the September 2007 quarter.  Given that Revenue in the earlier period was $545 million, this sets our target for the current quarter at $381 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) * $381 million = $95 million.

The company was very clear in May that it expects quarterly expenses for Depreciation and Amortization to be about $31 million.  This figure is 8.1 percent of our Revenue estimate, which is consistent with historical results.

Management 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 half's $77 million from the expected total for the year, and split the result evenly over the two remaining quarters, we get an R&D estimate for the September quarter of $51.5 million.  This is 13.5 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.  Based on what we've seen in the first two quarters, the savings should be much greater.  In the first two quarters of the year, SG&A expenses were about 29 percent of Revenue.  Given our $381 million Revenue estimate, our SG&A target for the third quarter is $110.5 million.

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 $60 million.  We will be more modest in our expectations, and look for the $22.5 million average of the first two quarters of 2008.

The estimates above would lead to an Operating Income for the quarter of $70 million, compared to the charge-driven $78 million loss in the September 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 second quarter's 34 percent, Net Income would be $53 million ($0.22 per share).

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) September 2008
September 2007
Revenue 381 545
Op expenses
CGS  (95) (198)
Depreciation (31)(37)
R&D  (51) (35)
SG&A  (111) (185)
Operating Income 70 (78)
Other income
Investments 0 (10)
Interest, etc. 10 8
Pretax income 80 (80)
Income tax (27)
Net Income 53 (41)
$0.22/sh ($0.17)/sh
Shares outstanding 245 243

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