08 November 2008

KG: Financial Analysis through September 2008

King Pharmaceuticals recently reported its results, and filed a 10-Q, for the third quarter of 2008.  This post provides the GCFR analysis of the financial statements dated 30 September.

King Pharmaceuticals, Inc. (NYSE: KG) manufactures and sells various brand-name prescription pharmaceuticals.  Headquartered in Bristol, TN, King now focuses on specialty products for the neuroscience, hospital and acute care markets. 

In 2007, 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.  The Court's decision resulted in King recognizing asset impairment charges (covering intangible assets and inventory) totaling $250 million and King laying off 20 percent of its staff.
King recently approached Alpharma, Inc. (NYSE: ALO) shareholders with a sweetened $1.55 billion acquisition offer.  This bid, 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 promising chronic-pain treatment known as REMOXY.

At less than $10 each, the current price of King Pharmaceuticals common shares is approximately 80 percent below the all-time high set in 2001.

Three months ago, when generic Ramipril became available from firms other than Cobalt Laboratories, our analysis of King's second-quarter results lowered the Overall Gauge score by 20 points.  The scores had been unrealistically high because the steep share price decline occurred well before King's sales contracted.

Now, with the data from the September quarter, our gauges are displaying the following scores:

  • Overall: 68 of 100 (up from 54) 

Before we examine the factors that affected each gauge, we will review the latest quarterly Income Statement and compare it to our previously communicated expectations.

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 2008
September 2007
Revenue (1)
388381 545
Op expenses

CGS (2) (101)(95) (198)

Depreciation (3)(30)(31)(37)

R&D  (34)(51) (35)

SG&A (4) (99)(111) (185)

Operating Income
12370 (78)
Other income

Investments 00 (10)

Interest, etc. 510 8
Pretax income
12880 (80)
Income tax
Net Income
8553 (41)

$0.34/sh$0.22/sh ($0.17)/sh
Shares outstanding
246245 243
1. Total revenues. Net Sales plus royalty revenues.
2. Cost of revenues, exclusive of depreciation, amortization and some impairments.
3. Depreciation and amortization, plus accelerated depreciation.
4. SG&A, plus special legal and professional fees, plus co-promotion fees.

Revenue in the recent quarter was 28.7 percent below that in the year-earlier period, but it beat our estimate by 1.8 percent.  We had expected Revenue to decline by 30 percent.  About 80 percent of the Revenue decline is due to reduced Altace sales.

The Cost of Goods Sold (CGS) in the quarter was 26.1 percent of Revenue, which translates into a Gross Margin of 73.9 percent.   Our target for the margin, based on company-provided guidance, was 75 percent. 

Depreciation expenses, at 7.6 percent of Revenue, were consistent with guidance and our expectations.

Research and Development expenses were 8.7 percent of Revenue, and they were a substantial $17 million less than anticipated.  Our target was based on management's guidance that R&D expenses in 2008 would be about $180 million.  Through the first nine months of the year, R&D expenses have totaled only $111 million.

Sales, General, and Administrative (SG&A) expenses were 25.6 percent of Revenue.  Our target had been 29 percent.  SG&A expenses were lower than our expectation mainly because King recorded an $8 million anticipated insurance recovery of legal fees in this line item.  Roughly half of the drop in SG&A expenses from last year's level was due to greatly reduced Altace co-promotion expenses. 

King often records asset impairment and restructuring charges that can determine whether quarterly earnings meet expectations.  In the September 2008 quarter, these charges were negligible.  In the last 10 quarters, the average charge has been over $50 million. 

King's Operating Income, which accounts for total sales and all operating expenses, more than reversed the loss seen in the September 2007 quarter.  In addition, Operating Income surpassed our forecast by more than 76 percent.  Our estimate proved too conservative because R&D, SG&A, and "special" expenses were all much less than we expected.

Interest income was $5 million less than forecast.  The income tax rate was 33.9 percent, nearly equaling the 34.0 percent guidance. 

For the reasons outlined above, Net Income was 60 percent more than our projection.

Cash ManagementSeptember
3 months
12 months
Current Ratio5.34.43.7
LTD/Equity 14.6%15.2%16.3%
Debt/CFO 0.7 yrs0.6 yrs0.7 yrs
Inventory/CGS 109 days106 days112 days
Finished Goods/Inventory 64.4%63.8%42.7%
Days of Sales Outstanding (DSO)45.2 days41.2 days44.9 days
Working Capital/Market Capitalization  50.2%41.8%37.0%
Cash Conversion Cycle Time86.9 days88.2 days106.5 days
Gauge Score (0 to 25)131722

On 30 September, King had over $1.2 billion in Cash or equivalents, which is far more than needed to meet current obligations.  This war chest demonstrates King's seriousness in its $1.55 billion acquisition offer for Alpharma (NYSE: ALO).

King would have difficulty liquidating its investments in auction rate securities, with a total par value of $438.3 million.

These factors explain why the Current Ratio and Working Capital-to-Market Capitalization ratios are extremely high. 

Debt, Inventory, and Days of Sales outstanding are all stable.  The lower Cash Conversion Cycle Time shows improved cash management efficiency .   The large proportion of Finished Goods in the Inventory is troubling, as it could be an indicator of slower than anticipated sales.

3 months
12 months
Revenue growth-17.3%-7.6%11.5%
Revenue/Assets 50.8%55.8%63.9%
CFO growth0.0%20.1%44.5%
Net Income growth 45.5%-56.8%12.8%
Gauge Score (0 to 25)8416
Growth rates are trailing four quarters compared to four previous quarters.

With rapidly declining sales and decelerated Cash Flow, Growth isn't a big part of the current landscape at King.  However, the increase in Net Income in the last four quarters is very encouraging.

3 months
12 months
Operating Expenses/Revenue 71.3%75.4%73.6%
ROIC 18.3%18.9%23.4%
Accrual Ratio-27.1%-26.3%8.8%
Gauge Score (0 to 25)161711

The loss of Altace exclusivity has, to no one's surprise, trimmed King's operating margin.  Nevertheless, the ROIC and FCF/Equity values remain quite appealing.  The oddly low Accrual Ratio, which suggests high earnings quality, is a result of non-Cash charges to Net Income.

3 months
12 months
P/E 9.119.316.1
P/E to S&P 500 average P/E 54.2%105.1%93.9%
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)221122

King's stock price fell over the course of the quarter from $10.47 to $9.58.  The valuation ratios above, which seem quite low, can be compared with other Drug Manufacturers.

The Cash Flow ratio should attract the attention of value investors.

3 months
12 months
Gauge Score (0 to 100) 685473

We acknowledged that our rearward-looking gauges were painting a too rosy view of King Pharmaceuticals during the initial period after the Altace decision.  Now that the Overall Gauge score has dropped and rebounded, we have more confidence in the optimistic results.  King was more successful at cutting its expenses than we had hoped, it turned a profit under challenging circumstances, it is well capitalized, and the valuation metrics are appealing.

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