12 May 2007

WPI: Financial Analysis through March 2007

Watson Pharmaceuticals (WPI), a manufacturer of generic and (to a lesser extent) branded pharmaceuticals, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. We updated our analysis to address certain details in this formal submittal that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

In November 2006, after resolving an FTC challenge, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. Andrx was both a maker of generic drugs (often controlled-release versions) and a distributor. Watson had been expanding beyond its roots as a generic drug manufacturer into higher-margin branded pharmaceuticals. However, the Andrx acquisition was something of a strategic U-turn because it increased Watson's concentration on generics. In addition, $497.8 million, more than 25 percent of the cost of buying Andrx, was classified as "in-process R&D" and expensed in its entirety during the fourth quarter of 2006.

When we analyzed Watson after the results from December 2006 became available, the Overall score was a modest 29 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 12 points. Cash Management was weakest at 4 points.

Now, with the available data from the March 2007 quarter, our gauges display the following scores:

Cash Management. This gauge dropped 1 point from 4 points in December. The Current Ratio is now 2.4, rebounding solidly after the Andrx acquisition temporarily depleted cash reserves. Long-Term Debt/Equity, as another consequence of the Andrx acquisition, is now a highly leveraged 63 percent. The debt ratio was 67 percent in December and 27 percent one year ago. Inventory/Cost of Goods Sold dropped sharply to 126 days from 153 days three months ago. The inventory level is back down almost exactly to the 125-day level seen in March 2006. The percentage of Inventory that is product ready for sale is 62 percent; the Finished Goods ratio was a record-high 65 percent in December, but it has been averaging under 50 percent. Taken together, the two inventory ratios hint that sales met or marginally exceeded expectations. Accounts Receivable were 61 days of Revenue, essentially matching the 60-day value one year earlier.

Growth. This gauge doubled the 8 points it achieved in December. Revenue growth, supercharged because of the inclusion of Andrx, is now 36 percent year over year, up from a mere 1 percent a year ago. Net Income growth is N/A because a massive, acquisition-induced in-process R&D charge produced a trailing 12-month Net Loss. CFO growth is a solid 19 percent, up from a 12 percent decline a year ago. Revenue/Assets jumped sharply to 63 percent, which probably reflects the increase in the proportion of sales due to high-volume generic drugs. The increase was probably also helped by last year's huge asset write off.

Profitability. This gauge increased 1 point from 12 points after the prior quarter. ROIC grew slightly to a weak 7 percent from 6 percent a year ago. FCF/Equity jumped up to a strong 22 percent from 13 percent. Operating Expenses/Revenue moved up in the last year from 87 percent to 92 percent. The change was due to a big decline in Gross Margin that was somewhat offset by reductions in Depreciation and R&D expenses. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from -5 percent to -9 percent (ignoring the asset write down).

Value. Watson's stock price rose a little over the course of the quarter from $26.03 to $26.43. The Value gauge, based on the latter price, dropped to a weak 5 points, compared to 6 points three months ago. The P/E and the PEG ratio are N/A because of the net loss over the last twelve months. If we ignore the $500 million write-down, the P/E is 49, but the PEG is still N/A. The average P/E for the Biotechnology and Drugs industry is 33. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, is 1.4, much less than Watson's historical average. The average Price/Sales for the Biotechnology and Drugs industry is 9.5.

Now at a moderate 34 out of 100 possible points, the Overallgauge moved up 5 points in the last quarter. Watson is in a state of transition as it digests Andrx, and, as a result, the financial story is confused. Sales and CFO is strong, and the drop in Inventory allayed one of our concerns. On the other hand, Gross Margin might stay weak because generic drugs are essentially commodities. The ROIC needs to be much higher to keep up with the company's expanded debt levels. The company appears expensive on the basis of adjusted P/E, but cheap on the basis of Price/Revenue. We need more time to see what financial form the company takes.

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