New drugs set to deliver

Volatility in the stock market has been on the rise as the fallout from the credit crisis rumbles on. In addition, very real fears regarding economic growth are feeding already-nervous investors’ anxiety. It is during periods such as these that stocks with defensive characteristics come into their own. 

"...we believe the outlook is better today than it has been for sometime due to three late stage drugs which should provide a boost to sales as soon as 2009."

It is also a reason why we remain committed to the pharmaceutical sector. Despite the industry facing challenges regarding patent expiration and consumer safety, the insulation from the whims of the business cycle and exposure to favorable demographic trends continue to make the sector appealing. 

In the case of King Pharmaceuticals (NYSE: KG, Stock Forum), the recent past has been dominated by the somewhat surprising loss of patent protection for pain relief treatment Altace. Granted, the patent was due to expire next year, but the earlier loss of protection means that King had less time to develop and transition users to variations of Altace.

The impact on performance is undeniable. Sales in the second quarter ending June 30 declined from $543 million to $397 million, a decline of $146 million. Driving the decline was a drop in sales of Altace of nearly $120 million. Although King announced a 20% reduction in the U.S. salesforce following the adverse court decision, for the moment sales have declined faster than expenses.

Another drug of concern for King was Skelaxin. This muscle relaxant was also under threat from generic competition; however, earlier this year King reached an agreement with CorePharma LLC to grant limited generic rights. Second-quarter sales show that sales are steady at $107 million, indicating Skelaxin will not be a repeat of the Altace experience.

So having dispensed with the bad news, where does this leave King going forward? In our view, and despite the poor stock performance, we believe the outlook is better today than it has been for sometime due to three late stage drugs which should provide a boost to sales as soon as 2009.

Remoxy is a treatment for chronic pain that lacks the “dose dumping” effect of current options that can lead to misuse and abuse. King and its partner Pain Therapeutics (NASDAQ: PTIE, Stock Forum) submitted a New Drug Application (NDA) to the FDA in June. The FDA has in turn granted a priority review. This action is taken by the FDA when they believe the new drug’s potential is significantly better than what is currently on the market.

We interpret this as a positive development. It also means the review is typically done within six months of the NDA submission. As such, King is expecting the FDA’s review to be complete before the end of the year.

In addition to Remoxy, King is also collaborating with PTIE on two other early-stage, abuse-resistant drug candidates for the treatment of pain. Although these are not immediate help, they contribute to a pipeline of products, which is important to any pharmaceutical company’s longer-term health.

Back to the present though, and there are two additional drugs for which King intends to file NDAs to the FDA before year end. They are Acurox, another treatment for pain, and CorVue, for cardiac pharmacological stress imaging.

Clearly, the loss of patent protection on Altace was a significant knock that the company is still working to overcome. However, with three near-term new drugs on the horizon, we believe King is in a strong position to recover.

And if the company did not have these promising new treatments in the pipeline, there is further reason for optimism. In our last report on King, we said we are sure management is keeping a watchful eye out for the next acquisition opportunity.

This has indeed been the case, but it won’t be easy. Since July, the company has been in talks to buy Alpharma Inc. (NYSE: ALO, Stock Forum). These discussions have thus far been fruitless. An initial all-cash offer was made for $33 per share. Last week, King raised the offer to $37 per share, which represents a healthy 54% premium over the Alpharma stock price on August 21, the last trading day before King’s interest became public.

Having been turned down by the board of Alpharma, King has taken the offer directly to shareholders and in the process turned the deal into a hostile takeover. Alpharma has in turn initiated a poison pill defense which King has gone to court to have invalidated.

We would prefer to see the deal done on a consensual basis. We also believe that King’s offer, which would be accretive to earnings in two years, is pitched at an acceptable level. The combination would create greater diversification, particularly with the addition of Alpharma’s animal health franchise, whilst also strengthening the core competency in pain management. Improved cash flows and the ability to pursue significant synergies through greater scale and efficiencies add to the positive outcomes a merger would create.

As such, we hope a deal can be concluded despite the initial bluster that is often the case when acquisitions are first proposed. We will not have long to wait, as the tender offer expires on October 10. It is also a testament to King’s solid financial footings that it is able to mount an all-cash offer such as this in the current climate of capital hoarding on Wall Street. 

Finally, from a technical perspective, prices encouragingly have formed a large base pattern between $8.26 and $12.69 during the past 12 months. This represents a welcome change in momentum following the steep decline in the latter part of 2007.

In the coming months, we anticipate further consolidation with a bias toward the upper end of the noted range. In our opinion, the size and duration of the base pattern implies that a decisive break above $12.60 is likely to trigger substantial gains and a revival of upward momentum.

There is little doubt that King has been the subject of negative investor sentiment following the loss of patent protection for Altace. On the other hand, the market seems willing to ignore the near-term impact that new drug treatments will start to bring pending FDA approval. As a result, the stock trades on an undemanding prospective price earnings ratio of just over 12 times.

We do not believe this fully reflects the potential of King's pipeline, financial strength, or potential combination with Alpharma. In time, we believe these factors will become better understood by the market and the stock will undergo a re-rating in early 2009.

Accordingly, King Pharmaceuticals will remain held in the Fat Prophets Portfolio.  

King Pharmaceuticals snapshot

King Pharmaceuticals, Inc. is a vertically integrated pharmaceutical company that develops, manufactures, markets, and sells branded prescription pharmaceutical products. The company operates through five segments: branded pharmaceuticals, Meridian Medical Technologies, royalties, contract manufacturing, and other. King's branded pharmaceutical products are divided primarily into four therapeutic areas: cardiovascular/metabolic, neuroscience, hospital/acute care, and other. The Meridian Medical Technologies segment consists of its auto-injector business, which includes EpiPen. In October 2007, the company sold its Rochester, Michigan, sterile manufacturing facility, some of its legacy products that are manufactured there, and the related contract manufacturing business to JHP Pharmaceuticals, LLC.