Description

Thesis
Over the last four months KV Pharmaceuticals (KVA) has shrunk from a ~$1.1billion market cap to $35mm.  The straw that broke the camel's back was a voluntary recall of virtually all of their products and a stoppage of all manufacturing. As investors have indiscriminately dumped the stock, they have ignored the numerous levers KV can pull to extend the runway for a turnaround and  developments at the management level that have radically transformed the company.  At these prices, KV represents a highly favorable call option on a  turnaround with significant upside potential.

Background
KV is a unique asset in the specialty generic/ branded pharmaceutical space. The company was founded in 1940s by Victor Hermelin, now Chairman Emeritus, and was run by his son Marc until he was terminated "for cause"  in early December 2008 and removed as CEO and Chairman of the Board. "For cause" is defined in Hermelin's contract as "(i) employee has committed a breach of a fiduciary duty, embezzlement, larceny, or has willfully failed to perform his duties to Employer, and in so doing has acted with full knowledge of all pertinent facts; and (ii) such act has had a  material and demonstrable adverse effect on Employer." Marc is still a member of the board. At this point no one on the outside knows exactly what Marc did wrong but most would speculate that it has something to do with the company's ongoing saga with the FDA (we'll get to that later). There's no getting around it that KV has had serious control/ management issues.

Were KV your run-of-the-mill, undifferentiated generic pharmaceutical  manufacturer, who would want the headache? But KV is a special asset given its extensive intellectual property, decades of accumulated industry know how, mature relationships with important distributors,  and  unique status as a hybrid  brand (36% of FY08 sales) and generic specialty (61%) model.  KV has made  a name for itself using proprietary technology  to reformulate existing drugs  and target new opportunities  that have high barriers to entry.  It has two primary divisions, Ethex which  is a niche generic player that focuses on controlled release, rapid -dissolve, and other difficult to formulate products. Ther-RX, their other division,  focuses on women's health drugs sold as brands with a leadership position in prenatal vitamins, anemia, and anti-infectives.

At a certain point every  company must ask themselves: If we closed up tomorrow, would we be missed? For KV the answer to that question is a resounding "yes."   Ultimately KV's customer base does not want to be beholden to the Tevas and Mylans of the world and  therefore it is in their best interest to support mid size generic players like KV.  Based upon conversations we have had, we are confident that KV's customers will take them back.

So what is the secret sauce that makes KV so valuable. As discussed above, KV has always gone after the most difficult to formulate drugs where there is the least amount of competition.  Metoprolol , the generic version of Toprol ($1.7 billion at peak sales) marketed by AstraZeneca, is the perfect example.  In May 2007 KV was the first company to receive FDA approval to market Toprol and still  dominates the market today (~70% of market for 100mg and 200mg and ~50% overall share across all doses).  For the average generic manufacturer, making a drug as complicated as Toprol involves too much risk, possibly necessitating as many as 15-20 pilot studies with no guarantee of a payout. Without the years and years of experience of a KV, most companies can't take those risks. In FY 2008 sales were $120mm  and 1H09 sales were  $71mm before things started falling apart. As things are shaping up, it appears as if KV will be of 1 of  only 3 suppliers of Toprol.

What Happened?
On January 26, 2009 KV voluntarily suspended the manufacturing and shipping of all of its products and agreed to conduct a voluntary recall of most of its products. The scope and depth of the recall are currently under discussion with the FDA.  Subsequent news releases indicated that most of the problems were technical FDA compliance issues. For the last 6 months KV has been addressing oversized pills in isolated lots but the fact that patients were permitted to complete their existing medications demonstrates the relatively mild nature of the threat.    This recall comes on top of a previously  announced FDA inspection that began in December.  Basically overnight KV lost of all of its revenues with no guarantee as to when they will return. 

How and why the stars have aligned for a KV turnaround

1)Liquidity and Balance Sheet - As of the last reported results for 2QF09 (Sept.), the company had $159mm of cash and $70mm in auction rate securities (primarily AAA
rated securities with long-term maturities secured by student loans which are guaranteed by the U.S. government).  On the liability side KV has drawn $30mm on a $320mm facility (expires June 2011) and issued $200mm of convertible debt that isn't puttable to the company until May 2013. The convert has no associated covenants.  Just to make it clear: the convertible debt is totally subordinated and the debt holders have no influence over KV until the put date comes. KV also has $43mm in mortgage debt which isn't due until  2021.  Given their current cash position, KV can easily manage the $30mm outstanding on the credit facility and doesn't have to deal with the convert for 5 years . As far as KV's cash position goes, the company caught a major break when the FDA  issued a non approval letter for Gestiva on January 26th which would have triggered a $74.5mm payment to Hologic  upon approval.  It goes without saying  that the FDA recall   will be costly but the mitigating factor is that the recall only reaches the consumer level for 2 products.  All of the remaining products are at the wholesale level. Finally KV will be  on the hook for 3rd party consultant fees and  litigation expense. 

2)Numerous levers to cut burn - Unlike other generic manufactures, KV has  a large variable component to its cost structure given its 330 person sales force for its branded division. On a quarterly  run rate they are  spending $12mm on R&D and $60mm on SG&A.   At this point it is all conjecture how much they will cut and when.  There is no reason why KV can't furlough these employees until they have more visibility. At this point management has every incentive to cut costs and right size the company.  

3)Management Control -  In what we think is one of the most significant events in the last couple of  weeks and perhaps in the history of KV , ex CEO Marc Hermelin filed a Form 4 on January 29, 2009  disclosing that he had removed himself as trustee over over 2,234,145 B shares. KV has 37,767,037 shares of Class A Common stock and  12,163,482 shares of Class B Common. Class A shares have 1/20 the vote of Class B shares. Prior to this filing, Heremelin controlled 8.1mm votes out of a total of 14mm (A shares/20 + B Shares),  giving him control over the board and the entire company.  That is to say, even when Hermelin was terminated in December, he still retained effective control of the company with the ability to appoint all board members.  This ownership structure had always been a thorn in the side of KV, as is often the case with family businesses that go public and try to have the best of both worlds.  Now that this choke hold has been removed, KV has the ability to transform itself  into a more shareholder friendly organization.  A good start would be addressing CEO compensation which has been outrageous  (Marc raked in ~4% of net income as a bonus on top of a $1.3mm salary).  Again just to conjecture, we surmise that  KV can now also come to the FDA and beg for a clean slate  given the change of control, especially since there has been bad blood between KV and the FDA for decades.  In the midst of this whole crisis, as confirmed by current management,  a new KV is emerging that wants to right what was wrong. In fact,  KV held its first conference call ever on December 5th, 2008 as they introduced their new CEO David Van Vliet upon the termination of Heremlin. 

4)Graduated Roll out eases cash burn -  What makes this such an interesting situation is that is there is little precedent for a recall on this scale.  At the same time,  management has been reluctant to release any timetable as to when they will be able to begin manufacturing and selling product again.  Although we have no ability to substantiate the claim, we think there is a good chance that the  FDA will  permit KV to reintroduce products on a per product basis, especially those products where patients have limited generic alternatives like Toprol.  The sense one gets from KV press releases  is not that their products were dangerous but that the company was not in compliance with FDA current Good Manufacturing Processes, again suggesting they will find a more expeditious way to work through this.  At these prices we're willing to bet that an overly cooperative KV -- this was a voluntary recall -- along with the help of 3rd party consultants can expedite this process and get KV back online in a reasonably timely fashion.

Valuation

Coming up with a fair value for KV given all of the variables involved and the intentional lack of disclosure is  understandably a difficult task. The way we are thinking about valuation is that this is a cheap option with a meaningful amount of time until expiration. The value of our option grows to the extent that management can demonstrate that the business is likely to survive, generate profits and ultimately grow. There are 50mm shares outstanding, $230 in cash and marketable securities, and $273 mm in debt (as discussed above) for a TEV of $74mm.   FY2008 (year ending 3/31/08) revenues were $603mm and gross margins were 69% resulting in $415mm of gross profit and $161mm of EBITDA. We are not suggesting that KV will even be able to get close to these numbers in the next year but once the company shows progress towards getting back to  normal operating conditions, the market will revalue KV.  It's a fair question to ask at what level of revenues will KV be breakeven.  The answer to this question obviously depends on how much they cut their operating expenses and the mix of branded vs. generics. As a guidepost, in 2006 KV generated $368mm in revenues and earned $36mm in total operating profits, suggesting that management will be able to run KV profitability even at  greatly reduced revenue levels.  For the record , PPE is listed on the books at $193mm, most of which includes  1 million square feet of real estate in St. Louis that KV owns and pharmaceutical production equipment that carry decent salvage values given the strict maintenance and care  requirements for the industry.

While the current price suggests  that KV will not be in business in a year, we take the position that the balance sheet puts time on KV's side and a lot of good things can happen between now and 2013, when the convertible is puttable.  Regaining the ability to manufacture would likely make the stock triple and regaining profitability would likely increase the value from that point.  No one likes to get involved with a story where there is limited visibility as to revenue, earnings, and cash burn, but we think the large base of existing approvals and ample balance sheet create an extremely compelling risk/reward.  

Catalyst

1) Incrased visibility relating to short term cash burn and production issues

2) Reintroduction of products