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Subject:  Difficult times ahead for the King Date:  5/26/2004  11:13 AM
Author:  steveting Number:  236 of 253

Hi guys,

I'll say it up-front that there are difficult times ahead for King Pharmaceuticals.

With the sudden resignation of the CEO and Chairman Jefferson J Gregory and President Kyle P Macione, questions are being asked about the credibility of the company's management and how a current team would lead KG out of the slump that they got themselves into in the first place.

2003 has been a horrible year for KG and its disappointing that management didn't acknowledge this. From the press releases, annual report and conference calls, one could easily be misled from management's spin that things are great with increased revenues and great cash being generated from operations. But when management hypes the good news and fails to address the problems related to the business, investors should be hearing alarm bells and cast a skeptical eye. Some of the things that that investors should be concerned about is:

(1) SEC investigation. Basically KG was caught with their pants down by overcharging Medicaid. Why didn't management have a system in place that would ensure Medicaid and other governmental agencies weren't over charged in the first place? From the 10K it appears that management is still having difficulty in calculating the amount due to Medicaid, since they consider it to be subjective and have to do the calculations manually. How can this be? Unless this is an industry wide problem in which the majority of pharmaceutical/biotechnology companies are also over charging and thus subject to the same investigation, the logical conclusion is that management goofed or at least weren't conservative enough. To date KG haven't satisfactorily addressed this most pressing issue.

(2) Inventory problems. Its clear management didn't have a clue on what was happening to channel inventories and let this slip by. One could have seen this by the growth in inventories against growth in revenues for the past 9 quarters on a year-on-year comparison (Y-o-Y) as shown below. Revenue and inventory values are in millions.

Year 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04
Revenue $258 $282.5 $315.7 $272 $338.4 $370.7 $424.2 $388 $290.6
Y-o-Y 42.33% 36.81% 37.21% 6.95% 31.14% 31.21% 34.37% 42.65% -14.12%
Inventory $130.5 $148.8 $137.9 $167.1 $209.2 $252.5 $251.7 $260.8 $251.1
Y-o-Y 61.96% 71.28% 42.30% 49.81% 60.30% 69.66% 82.42% 56.08% 20.05%

As can be seen, inventory has been growing significantly faster than revenues and it was just matter of time before it become unmanageable. Thus it's not surprising that revenue took a hit in 2004 Q1 and wouldn't be surprised on disappointing news in next few quarters. So there's going to be more pain ahead (less revenue and earnings, more write-offs) until inventory levels are at a more reasonable level. This assumes that KG's sales force of 1,300+ individuals continue to sell and maintain the prescription demand. Another alarming trend is the increase in inventory valuation allowance – basically written off inventory which is now at record level of $60 million as at 2004 Q1. If one adds back the inventory valuation allowance the inventory growth is even worse.

(3) Special items. This one of the things that management continuously hype in their press release and conference calls when reviewing the income statement. For those who aren't familiar with this, management likes to give both non-GAAP and GAAP income statements to confuse investors. The non-GAAP income statement excludes special items that management determines to be non-reoccurring and does not represent the underlying fundamentals of the business. While there are pros and cons over this, it's obvious that the non-GAAP income statement paints a much prettier picture of how well the company is doing. The problem here is that there have been a lot of these “special items” in 2001, 2002, 2003 and its continuing into 2004. So why is management continuing with this charade? More power to the investor? I doubt it. As an investor, be skeptical on any non-GAAP statements that management spins out.

(4) Buying duds. KG has made a name for itself as an acquirer of FDA approved patented drugs and doing a great job of re-marketing. The pros of this is less risk in the drug development cycle, offset by the risk of buying duds and facing generic competition. If management maintains focus and minimizes the amount of duds being bought and/or delays the introduction of generics, then the payoffs can be huge. Examples of smart acquisitions are: Altace, Levoxyl, Thrombin-JMI, Meridian auto-injectors and Adenosine. However, when things go wrong the pain is felt in terms of lost sales, write offs and earnings hit. Some of the drugs that management made a swing for and missed are (numbers are in millions):

Drug Name Cost Impairment Other comments
Lorabid $91.7 $66.8 $79.8 additional purchase commitments
Florinef* $286.5 $111.0 $22.6 additional asset to be impaired
Not specified $13.6

*Cost includes purchase of Corzide, Delestrogen & Corgard.

More recently some of the drugs that are under a cloud due to generics or slowing sales are (numbers are in millions):

Drug Name Cost Asset Value Comments
Skelaxin $850.4 $814.4 With: Sonata
Prefest $118.3 $108.5
Nordette $203.0+ $96.0 With: Wycillin & Bicillin
Cortisporin $22.8 $18.3
Tapazole $18.2

The main concern here is generic threat to Skelaxin, a key product that brought in $179 million in revenue for 2003 and expected to generate $210+ million for 2004. KG took a big risk when purchasing Skelaxin and Sonat