A Compelling Case for King Pharma
We believe new management at King Pharmaceuticals (KG: $19) has done an admirable job so far in rectifying the company's past woes, defending its key franchises, and expanding the product portfolio. While King is expected to eventually face significant patent erosion on key products in the years ahead, we believe new product development projects, especially in the area of pain management, bode well for long-term growth. We also see future prospects enhanced by additional product acquisitions or in-licensing opportunities, which would be financed through ongoing strong cash flow and the company's over $900 million in cash.
King stock presently trades at deep discounts to peer specialty pharmaceutical companies on key valuation metrics such as p-e (price-earnings) and price-to-sales. We think the wide gaps in these valuations should narrow as the company succeeds in defending key franchises and in-licenses other growth drugs. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
King Pharmaceuticals was formed by the Gregory family in 1994, with the purchase of a plant in Bristol, Tenn., to manufacture drug products under contract for major pharmaceutical companies such as GlaxoSmithKline (GSK) and Novartis (NVS). A key part of its business strategy consists of the acquisition of branded prescription drugs being divested by large global pharmaceutical companies. To date, the company has successfully acquired and commercialized more than 35 branded products, and has introduced several product line extensions.
Range of Treatments
Sales of branded pharmaceuticals accounted for 87% of total net revenues in 2005, Meridian Medical Technologies (a maker of auto-injectors acquired in January, 2003) 7%, royalties from licensed drugs 4%, and contract manufacturing and other 2%.
The company's most important product is Altace, a heart drug acquired together with two other products from Hoechst Marion Rousel in 1998, for $363 million. An angiotensin converting enzyme (ACE) inhibitor indicated for the treatment of hypertension and congestive heart failure, Altace had 2005 sales of $554 million, up from $347 million in 2004. Other cardiovascular drugs include Corzide for high blood pressure, Procanbid treatment for arrhythmia, and Thalitone, a diuretic.
King also produces Skelaxin, a muscle relaxant (sales of $345 million in 2005); Thrombin-JMI, an acute care treatment ($221 million); Levoxyl, a thyroid hormone replacement treatment ($140 million); and Sonata, an anti-insomnia treatment ($83 million).
Other drugs include anti-infectives such as Bicillin, Cortisporin, and Neosporin; Intal and Tilade oral multi-dose, nonsteroidal inhalers to treat asthma; and Bevital acute-care treatment. King also provides contract manufacturing for large pharmaceutical companies.
License and Grow
The company markets its branded drugs to general/family practitioners, internal-medicine physicians, cardiologists, and hospitals across the U.S. through about 1,000 sales personnel. About 69% of sales in 2005 were derived from three key drug wholesalers: Cardinal/Bindley (28%), McKesson (MCK) (27%), and AmerisourceBergen (ABC) (14%).
We think King has executed well in recent years on its strategy of acquiring or in-licensing relatively small, niche-oriented drugs from big pharma companies, and developing them through targeted and focused marketing and promotional campaigns.
During 2004, King underwent a top-management shakeup, with new President and CEO Brian Markison taking the helm. We believe Markison's leadership has succeeded in correcting many of the company's past corporate-governance and wholesaler inventory management issues, as well as in streamlining King's cost structure and moving more aggressively on in-licensing and acquisition opportunities.
The company also initiated a comprehensive business strategy, which we believe has realigned its organization and positioned it for growth in the years ahead. A key element of this strategy is focusing on core competencies in three therapeutic categories: cardiovascular/metabolic, neuroscience, and hospital/acute care.
While generic threats to principal Skelaxin and Altace drugs have increased, we believe the company is taking the appropriate steps to hold these challengers at bay for several years. With respect to Skelaxin, we think King's planned filing of an amended citizen's petition with the FDA to block generics now stands a good chance of being upheld, given the FDA branded division's approval of a new Skelaxin label in December, 2006. The new label includes more specific warnings for patients taking the drug with food, based on new clinical pharmacology studies presented by King.
Although the FDA's generic division decided in 2004 that warnings over the food effects could be removed from generic labels (making it easier for generics to launch "at risk," before resolution of ongoing patent litigation with King), we think the FDA may be more reluctant to approve such a carve-out now, thereby reducing the likelihood of a generic launch "at risk." We believe generics will be blocked at least until 2009.
King is also taking steps aimed at protecting its important Altace and Thrombin-JMI franchises. Specifically, the company has developed an Altace/diuretic combination, which it plans to file with the FDA during the second half of this year. It has also developed new formulations of Altace through collaboration with Arrow International (ARRO). Similar line expansions are planned for the Thrombin-JMI line.
We think these and other life cycle management strategies should enable King to salvage a good portion of its Altace and Thrombin-JMI sales when generics and other competition hits over the coming years. In addition, the company recently formed a partnership with Depomed (DEPO) to market Glumetza, a once-daily extended-release version of metformin for the treatment of type-2 diabetes.
King is also moving aggressively to become a leader in pain management. Building on its existing Skelaxin muscle pain franchise, the company has agreed to acquire Avinza, a once-daily treatment for chronic pain that contains morphine in an extended release form. We see significant potential for this product, which is being directed to a $7 billion opiate market that serves over 50 million Americans affected by chronic pain.
Looking for representation in the huge potential market for abuse-deterrent opiates, the company acquired worldwide commercial rights to Pain Therapeutics' (PTIE) Remoxy abuse-resistant oxycodone painkiller in 2005. Results from a pivotal Phase III clinical trial on Remoxy should be available later this year, and an NDA filing is planned for 2008. King is also developing a new chemical entity called T-62, which is a novel treatment for neuropathic pain.
We expect total company sales to rise about 8.6% in 2007, largely reflecting further growth in the key Altace cardiovascular and Skelaxin muscle-relaxant franchises, based on our assumption that King will be able to stave off generic competitors. Altace sales should benefit from a recent restructuring of a co-promotion deal with Wyeth (WYE) that gave King full marketing rights to that drug. We also see further growth in the Thrombin-JMI critical-care line, and initial sales from the planned acquisition of Avinza once-daily morphine drug. However, we expect sales of Levoxyl and other older products to decline.
We look for gross margins to narrow slightly in 2007, on a less profitable sales mix. We think that selling, general, and administrative (SG&A) costs will approximate those of 2006. We anticipate R&D expenses to increase moderately on costs to develop Remoxy and other R&D compounds. Interest and other income should be higher. We project EPS of $1.72 for 2007, up slightly from the $1.70 we see for 2006.
We expect operating cash flow to increase over 30%, to over $500 million, in 2007. As of Sept. 30, 2006, cash and cash equivalents, plus investments in debt securities, totaled about $918 million, up from $525 million at the end of 2005.
The shares were recently trading at 10.9 times our 2007 EPS estimate of $1.72, and about 2.1 times our 2007 revenue forecast of $2.1 billion. These metrics represent significant discounts to both specialty-drug stocks and the market as a whole due to what we perceive to be excessive investor concerns over generic threats to Skelaxin and Altace. We believe that as these concerns are allayed, multiple expansion will follow.
Based on our projected three-year EPS growth forecast of 5%, we calculate a p-e to estimated five-year growth (PEG) value of 2.1 for King, comparable to the average PEG for the overall specialty-drug group. Our 12-month target price of $23 applies a p-e of 13.4 times our $1.72 estimate for 2007. We believe this projected p-e, which is at a modest discount to peer specialty-drug stocks, is appropriate given the company's inherent business risks.
Our discounted free cash flow (DCF) analysis also indicates an intrinsic value of about $23, which is approximately 23% above the recent market price.
We believe previous management was deficient with regards to internal controls, which led to questionable accounting and a restatement of historical financial results for the years 2002-04. However, we think these issues were largely resolved by the company's new management, which implemented tighter controls and improved overall corporate governance.
Key corporate-government characteristics that we view favorably at King include a board consisting of at least two-thirds independent directors, and the fact that all members of the audit, compensation, and corporate-governance committees are independent directors.
On the negative side, the company has a "poison pill" shareholder-rights plan in place, and a supermajority vote of shareholders is needed to change certain provisions of the charter or bylaws.
Risks to our recommendation and target price, in our view, include the possibility that the company's patent-defense and lifecycle-management strategies don't succeed, especially with regard to the planned citizen's petition to the FDA to block generic challenges to Skelaxin. Another risk is the success, or lack thereof, of lifecycle-management programs for Skelaxin, Altace, and Thrombin-JMI. Possible disappointments in clinical development of the Remoxy pain drug, as well as the company's inability to acquire or in-license other promising products, represent additional risks.