FOOL ON THE HILL: An Investment Opinion
King Pharmaceuticals has focused on buying unwanted divisions of drug companies with the intent of enhancing marketing and improving performance. These acquisitions led to strong earnings and a hefty stock price valuation, but also a highly leveraged balance sheet. Several recent moves have improved the company's balance sheet and growth prospects. Nonetheless, a proposal to acquire Jones Medical has hammered the stock, which perhaps gives investors a royal opportunity to buy shares.
Some of the King's acquired brands include Anusol-HC, Neosporin, and Cortisporin, which were purchased from Pfizer (NYSE: PFE) and Glaxo-Wellcome (NYSE: GLX). These various acquisitions and King's execution seem to have worked well together. Between 1997 and 1999, King's sales soared from less than $50 million to almost $350 million. More importantly, trailing 12-month earnings per share jumped 60% to $0.73 over the past year. These numbers lend credence to the hypothesis that King is doing what is planned -- to profitably acquire and grow its products.
Among it's numerous purchases, King found one that's probably going to end up being a gold mine. In December 1998, the company purchased rights to Altace, Silvadene, and AVC from Hoechst Marion Roussel for $363 million. Altace, an ACE inhibitor (an antihypertension drug) with $84 million in 1997 sales, was the biggest drug in the group. It was a nice drug that had decent prospects. In December 1998, the drug had a healthy 11% growth in prescriptions.
In November 1999, however, the drug received a tremendous boost. A five-year study to evaluate the efficacy of the drug in preventing heart-related deaths was stopped early because of its success. The New England Journal of Medicine published an article on the study prior to its scheduled publication date because the impact was considered so substantial. King's stock more than doubled over a one-week period on this news.
To the extent that this product was a major portion of King's overall sales, a big boost in Altace sales could dramatically impact the company's overall performance. Based on 1999 numbers, a 50% increase in Altace would translate into 17% overall company growth -- if nothing else changed! And a good portion of that sales increase would drop straight to the bottom line due to the product's high gross margins.
Did these improved sales materialize? Well, during the second quarter of the year, Altace sales increased 63% over the prior year. The number of new prescriptions and total number of prescriptions jumped up 59% and 35%, respectively, indicating that this growth should have legs. And this is before getting approval to market these new indications. The company has filed for this approval, which should be forthcoming soon (an advisory panel recommended approval in May).
To be ready to market heavily when this approval comes, King and American Home Products (NYSE: AHP) have entered into a co-promotion agreement where American Home will use its massive sales force to help market Altace.
While King had a lot of attractive attributes, I hesitated to invest in the company because of its weak balance sheet. At the end of September 1999, the company had over $600 million in debt and only $133 million in equity, a debt/equity ratio of over 450%. Most of this debt had been expended for acquisitions, but I was concerned about paying a high earnings multiple for such a leveraged company.
Several things have happened that have reduced King's debt load since then. During the first quarter, the company acquired Medco Research in an all-stock transaction that increased its equity and reduced its debt. Following that, the company completed a 4-million share follow-on offering that raised another $165 million. Then in June, as part of the Altace co-promotion deal with American Home Products, King sold $75 million worth of stock to that company. A good portion of this cash was used to reduce debt.
Looking at King's balance sheet as of June 30, 2000 is a much more pleasant exercise than nine months earlier. Total debt stands at about $290 million and shareholders equity has jumped up to $477 million. Combining those two numbers together, King has a debt/equity ratio of 37% -- a far cry better than the 450+% in September.
My other concern about King was its valuation. At the end of June, the company was trading for roughly 50x earnings estimates for the current year, with long-term growth projections in the 23% range. Now, I know that drug companies tend to have higher earnings multiples than many other industries, but I still didn't feel comfortable paying such a high price for King's opportunities.
Earlier this month, King announced that it was going to enter into its biggest acquisition to date, the $3.4 billion all-stock purchase of Jones Medical (Nasdaq: JMED). King's stock quickly dropped from $45 per share into the $30s. Yesterday, King stock closed at $32 7/16, 37x this year's earnings estimates.
Acquiring companies typically see their stock drop some on the announcement of a big deal, as investors fear the acquirer overpaid for the acquiree, but the greater than 20% plunge in King's stock was more than normal. Most likely, investors fear the benefits of Altace will have less of a positive impact on a much larger company.
Jones Medical had $132 million in revenue and $49 million in profits (hmmm... that's a 37% net profit margin!) last year that will be added to King's $348 million and $45 million respective figures. On top of having larger absolute earnings numbers, King will have an additional 77 million shares outstanding that will participate in the Altace's growth. While that growth will be shared, Jones hasn't been a slouch. The acquiree has grown its earnings at a 34% compound annual rate over the past four years. The future also looks bright, with a 22% long-term growth forecast (almost the same as King's).
King's Looking Interesting
King looks more attractive to me now than it ever has. The expanded marketing approval for Altace should lead to much higher sales of that product. The company's balance sheet has been cleaned up dramatically (the Jones deal will bring another $175 million cash to King's balance sheet). And to top it all off, the valuation has been knocked down a few notches. The pending Jones transaction will add some diversity to the company, but shouldn't slow down overall growth.
King's successful acquisition history gives me confidence that it made a smart decision to acquire Jones. While merging with such a large company will create challenges and obstacles, I'm comfortable betting that King management will be up to the task. Assuming they can execute similarly to how they've done in the past, King's future looks royal.