From the 4Q 2003 earnings and press releases, one would think that things aren't going well for KG, some of concerns include:(a) CEO resigning;(b) Overcharging of Medicaid. The internal audit suggest that KG had under estimated the amount of money overcharged to government programs, with an additional increase of $18.9 million on top of the $46.5 million previously advised. The total amount overcharged now comes to $65.4 million, a 40% increase;(c) Inventory management problems with revenue of KG's top selling drug Altace falling;(d) Total revenue falling short of analyst's expectations and earnings not exceeding the average estimate of $0.32 per share, before special charges;So why has the stock price gone up with the bad news? Let's have a look at points mentioned. (a) In the conference call, Jefferson J. Gregory mentioned that he's resigning as the CEO due to a new baby and the completion of the internal audit on the overcharging of Medicaid and other governmental programs. This isn't as bad as it looks since KG intends to separate the Chairman and CEO positions. Jefferson J. Gregory who held both positions of Chairman and CEO will stay on as Chairman until the end of the year when he's up for re-election. For a growing pharma such as KG, separation of these 2 important positions is a positive sign. A new CEO and possibly a new Chairman would bring in new ideas on how the company can grow and implement change.(b) SEC investigation. For now this seems to be one of the biggest concern to shareholders. When will it end and what will the fines be? No one knows and your guess is as good as mine on this one. But it's going to take years for SEC to go through KG's internal audit as well conducting their own before we all know what the true picture is. The good points are that KG has been forthright in their error, made restitution, and is in the process of implementing a system to overcome the Medicaid pricing issues. The bad point is that KG wasn't conservative enough in the first place, which got themselves into trouble with the SEC and is a lesson all investors should note.(c) Inventory management. This is more problematic then it looks. Inventory is at high levels and it's clear that KG has problems with their wholesalers with some having 3 months worth of supplies. Without the write off of Lorabid, inventories would have grown by an extra $30 million – a record level. KG needs to work their inventory down to a more reasonable and manageable level – say about 1½ months. As inventory is worked down it will have an impact on revenue with lower sales. It happened for Levoxyl in 3Q 2003, but revenue recovered in 4Q 2003. It's going to happen for Altace in 1Q 2004 too, so KG will experience some pain while it goes through this exercise and it's unfortunate that they hadn't kept one eye on the wholesalers and another on their inventories earlier. On a year over year comparison, inventory grew slightly more than sales and it bears closer scrutiny.(d) Analyst's expectations. I can't say much on this as for analysts tend to be overly optimistic in the first place and they probably have more resources to justify their expectations. The question to be asked is if KG represents value today? KG's revenue grew an impressive 34.8% to $1.52 billion from the previous year of $1.21 billion, most of it due to acquisitions of Meridian Medical Technologies, products bought from Elan of Selaxin and Sonata as well as growth from it's own branded products of Altace and Thrombin-JMI. But growth is slowing down this year, as revenue at the top end of estimation will come it at $1.85 billion - a 21% increase. From an earnings perspective and excluding special items, 2004 will come in around $1.60 at the top end of expectations compared to $1.41 for 2003 – a 13.5% increase year on year. More important is the cash generated by the business. Unfortunately KG didn't release a cash flow statement so it's hard to work out the structural free cash flow (SFCF) number, as there's no information on the capital expenditure. I've estimated 2003's SFCF to be about $504 million based on the following equation:SFCF = Net earnings + depreciation & amortorisation (+ or -) one time expenses – capital expenditureThe one time expenses are non-cash items and those that KG refers to as special items not related to the underlying business. These non-cash items include intangible asset impairment and in process R&D, which come up to $316.8 million for 2003 on the income statement. It's extraordinarily high and the main reason why KG swung into negative earnings for 4Q 2004, 1Q 2003 and 2Q 2003.I've extrapolated the capital expenditure from 3Q 2003 result of $33.5 million for a full year of $44.7 million. I need to confirm this number in the 10K filing when it comes out, but it's a good enough estimate for the time being.The net income, depreciation and amortorisation is found on the income statement, so the SFCF = 105.8 + 124.5 + 318.6 – 44.7 = $504 million. The SFCF is exceptionally high and as previously said, it's due to the write down of non-cash items.As at 19-Jan-2004, KG's stock closing price is $19.25 and with 241.145 million diluted shares outstanding, the market capitalization comes out to $4,642.2 million. On the balance sheet KG has $214.6 million in cash (which includes money owed to Medicaid) and $466.8 million in debt. That comes to a net debt position of $252.2 million.That means KG's enterprise value (EV) is market cap + net debt. If KG had a net cash position then it would be subtracted from the market cap. In other words KG's enterprise value (EV) comes out to $4,894.4 million, making the EV/SFCF multiple of 9.7x. That's significantly better than previous year's number of SFCF of $235 million and an EV/SFCF multiple of 18.5x. I'd view this with a pinch of salt as the non-cash special items had skewed the SFCF number, but there's very little doubt that KG is a magnificent cash-generating machine with a SFCF margin (as a percentage of revenue) of an amazing 33%. Again, I'd check the 10K filings to confirm this and I'm a little skeptical that KG can maintain this going forward.Even using KG's projected 2004 earnings of $1.40 and with 19-Jan-2004 closing price of $19.25, the P/E ratio comes to 13.75x. That seems reasonable considering earnings are expected to grow at 13.5% and revenues are going to grow 21% for this year.If KG can sort out its inventory problems, continue to expand sales and execute its business plan, then overall the value is still reasonable even after the recent run up in price. Though I believe that developing their own products is good thing in the long term, acquisitions is still the best way forward until KG's R&D can prove itself by making a block-buster product.I'd be interested to know what others thought of KG's performance for 2003.Regards,Steveting
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