It's funny how the market can fall in love with a given stock for a time, seeing nothing but blue skies and butterflies, only to turn on it like a spurned lover when the company fails to live up to the market's impossible expectations. When the market consensus turns negative, the scorned stock will often fall to levels so low that any positive development is sufficient to produce a nice run-up.
King Pharmaceuticals (NYSE:KG) offers a recent case study in this love/hate cycle. King has an impressive track record as a specialist in acquiring and marketing drugs. Starting with a $5 million investment in 1994, it acquired more than 40 products and grew revenues from a mere $20.6 million in 1996 to over $1 billion in 2002. Such explosive growth made it a big favorite among investors, and at its height in late 2001, King enjoyed a market cap north of $10 billion. Such a valuation required a perfect company and perfect execution to justify the price, and as we should all know by now, perfect companies only exist in stockbroker fairy tales.
Breaking up is hard to do
King had already fallen into the investor doghouse when I highlighted the stock for Motley Fool Select (now Hidden Gems) readers in Nov. 2002. The stock had been clobbered from its lofty perch of over $40 a share all the way down to the high teens. This was just as management announced that it would be acquiring one of my favorite companies, Meridian Medical Technologies, in what I thought was a fantastic deal for King.
Several events conspired to push the stock out of favor. The first was speculation that one or more generic drug companies would succeed in challenging the key patent protecting King's biggest-selling hypertension drug, Altace. Given that Altace comprised more than 40% of 2002 revenue, this would be dire indeed. Similar concerns were voiced by Wall Street analysts regarding King's thyroid drug Levoxyl. This class of drugs, which is dominated by Abbott Laboratories' (NYSE:ABT) Synthroid, had been sold in the U.S. for decades, but had never been formally approved by the FDA. In 1997, the FDA announced all companies marketing such products in the U.S. would have to submit marketing applications to the FDA. King's version of the product was approved by the FDA in May 2001, and the company filed applications for more than 20 patents protecting its formulation of the drug. Those patents were still pending in late 2002, causing some analysts to speculate in their research reports that, absent an issued patent, generic competition would arrive as early as mid-2003.
A cornucopia of concerns
As if worries about imminent generic competition for two of its biggest drugs weren't enough, the controversy over hormone-replacement therapy kicked off by a National Institutes of Health study in the summer of 2002 hit King right after it had acquired the Ortho-Prefest line of hormone therapy pills from Johnson & Johnson (NYSE:JNJ). If the timing on the J&J deal wasn't bad enough, it became clear King had overpaid for its late 2001 purchase of four products from Bristol-Myers Squibb (NYSE:BMY), of which beta-blocker Corzide was the crown jewel. According to a Forbes article at the time, King's $285 million offer topped 15 competing bidders. This last was an indication to many that the drug acquisition business model that King helped popularize was becoming way too competitive. Worse, it implied that management might be willing to pay any price in order to grow -- a cardinal sin for any acquisition specialist. I thought that the acquisition of Meridian was ample evidence that King hadn't lost its golden touch.
As it turns out, I was too early; more bad news was on the way. On March 13, 2003, King dropped a bomb on its investors when it disclosed that the SEC had initiated an investigation of the company's Medicaid pricing practices. The stock fell 23% that very day. At the time, I decided to hold on despite my misgivings about the investigation, believing there was a good chance the market overreacted to the news. Within a month, the stock was back over $15. At that point, I sold King to buy another stock that I liked better. But Wall Street soon provided another chance to buy it at a bargain price.
The other shoe drops
In late Oct. 2003, King got whacked again, falling from $16 to $12.85 after missing its third-quarter earnings per share estimate by a penny and producing only $424 million in sales (versus a "consensus" estimate of $430 million). Also, management provided very conservative forecasts for 2004 earnings. All the Wall Street analysts immediately downgraded the stock. If there is one thing analysts absolutely hate, it's quarter-to-quarter variability in earnings. One research report noted at the time that "investors are likely to maintain a significant discount until King is better able to accurately forecast revenues for its important drugs." Nobody seemed to care that the "disappointing" 2004 revenue and earnings forecast of $1.75 billion to $1.85 billion and $1.50 to $1.60 in EPS translated into less than 10 times earnings at the prevailing stock price. Free cash flow could be as high as $400 million in 2004, meaning that at $12.85 King was trading at about 7.5 times its free cash flow. This seems too cheap for a company growing sales and earnings at double-digit rates and sporting net profit margins of over 25%.
The perception change begins
Since then, a couple of things have happened. King has conducted an internal audit, and has disclosed that it unintentionally underpaid amounts due Medicaid and other government pricing programs by approximately $65.4 million. It has escrowed this money and is actively cooperating with the SEC investigation. The feared patent challenges to Altace and Levoxyl do not appear likely to result in any immediate generic competition for these products, and maybe none until 2006. Last year's big acquisition of two drugs from Elan (NYSE:ELN) has turned out all right, at least initially. Meridian is performing beautifully as part of King. The recent fourth-quarter earnings release, while not particularly well received by analysts, nevertheless led to grudging upgrades from "sell" to "hold." The stock has bounced off its lows under $13 to a recent $19 in three months.
While King has now worked its way off the "world's-most-hated-stocks" list, the company still has far to go to get back into the good graces of institutional investors and Wall Street analysts. Even now the stock trades at only about 12 times 2004 estimated free cash flow. While King isn't out of the woods yet on either the SEC investigation or in mitigating the near-term risks to its business, I think it's too early to sell. A highly profitable drug company deserves at least a mid-teen multiple, which would put fair value at somewhere in the $25 range. I won't be surprised if the analysts then begin to take a shining to the stock they couldn't stand at $12 -- at twice the price -- and the cycle of love and hate will begin anew.
Guest columnist Zeke Ashton has been a longtime contributor to The Motley Fool. Zeke is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At the time of publication, Zeke owned shares of King Pharmaceuticals in some client accounts. Please send your feedback to [email protected]. The Fool has a disclosure policy.
