07 November 2007

WPI: Financial Analysis through September 2007

We have analyzed Watson Pharmaceuticals' (WPI) preliminary financial results for the quarter that ended on 30 September 2007. The published Balance Sheet omitted various details, including those characterizing Watson's inventory, current liabilities, and stockholder's equity. Our evaluation will be updated after the company files a complete 10-Q report with the SEC.

Watson develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products. In November 2006, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. [More than a quarter of this cost was later expensed as "in-process R&D."] Andrx made and distributed generic drugs, often controlled-release versions. Watson had been expanding beyond generic drugs into higher-margin branded pharmaceuticals. However, the Andrx acquisition reversed this strategy and generics became responsible for over 75 percent of revenues.

Many branded pharmaceutical products will soon lose their patent protection, which increases the attractiveness of generic drug manufacturers to investors.

When we analyzed Watson after the June quarter, the Overall score was a solid 45 points. Of the four individual gauges that fed into this composite result, Growth and Profitability were strongest at 17 points each. Value was weakest at 7 points.

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

Before we examine the factors that affected each gauge, let's examine the latest quarterly Income Statement. We did not issue a pre-release prediction of Watson's earnings for September quarter.

($ M)
September 2007
September 2006
595 440
Op expenses

CGS (346) (258)

Depreciation (44) (39)

R&D (36) (29)

SG&A (112) (64)

Other 0 (0)
Operating Income
56 49
Other income

Asset sales 6 0

Interest, etc. (7)
Pretax income
37 55
Income tax
Net Income
35 34

0.295/share 0.296/sh

Watson's Revenue in the recent quarter was 35 percent greater than in the pre-Andrx year-earlier period. The Cost of Goods Sold (CGS) was 58.3 percent of Revenue, essentially unchanged from 58.5 percent in September 2006. Depreciation expenses were 7.4 percent of Revenue, down from the year-earlier value of 8.9 percent. Research and Development (R&D) expenses were 6.0 percent of Revenue, compared to 6.7 percent in September 2006. Sales, General, and Administrative (SG&A) expenses were 18.9 percent of Revenue; SG&A expenses were a significantly less 14.6 percent of Revenue one year ago.

The higher Revenue proved more significant than the increased SG&A expenses, leading to Operating Income a substantial 14 percent above the amount attained in September 2006. [Note that our definition of Operating Income is somewhat different from the company's.]

Non-operating income was $7 million less in the recent quarter than the year-earlier quarter. A one-time $6 million gain in the recent quarter made the comparison less severe.

The Income Tax Rate in the recent quarter was 37.5 percent, compared to 37.3 percent. Net Income was microscopically higher than the level attained a year ago.

Cash Management. This gauge increased from 9 points in June to 10 points now.

The measures that helped the gauge were:
The measures that hurt the gauge were:

Growth. This gauge decreased from 17 points in June to 13 points now.

The measures that helped the gauge were:
  • Revenue growth = 40.2 percent year-over-year, up from 7.6 percent
  • Revenue/Assets = 72.1 percent , up from 55.5 percent in a year; it's not surprising that more high-volume generic drugs in the product mix would improve sales efficiency.
The measures that hurt the gauge were:
  • CFO growth = 1.4 percent year-over-year, disappointing but up from 0.5 percent.
  • Net Income growth was N/A because the enormous $500 million charge at the end of 2006 for in-process R&D causes net income for the trailing four quarters to be negative.

Profitability. This gauge decreased from 17 points in June to 15 points now.

The measures that helped the gauge were:
  • FCF/Equity = 17.7 percent, up from 15.1 percent in a year
  • Accrual Ratio = -20 percent, down from -8.2 percent in a year. Although negative values for this ratio are good, we're not used to values this low.
  • ROIC = 9.6 percent, up from 5.5 percent in a year.
The measures that hurt the gauge were:
  • Operating Expenses/Revenue = 91.6 percent, up from 90.1 percent in a year. This is also a consequence of more lower-margin generic drugs in the product mix.

Value. Watson's stock price dropped slightly over the course of the quarter from $32.53 to $32.40. The Value gauge, based on the latter price, dropped to 6 points, compared to 7 points three months ago (and 8 points twelve months ago).

The measures that helped the gauge were:
The measures that hurt the gauge were:
The average P/E for the Biotechnology and Drugs industry is 31. The average Price/Revenue for the industry is 8.3.

Watson continued to consolidate the Andrx acquisition. In previous quarters, we saw evidence of operational efficiency improvements; however, this evidence was much less apparent in the recent quarter. As a result, income and cash flow were squeezed. The negative trailing-year Net Income caused by the $500 million charge related to the Andrx deal throws the Value gauge out of whack.

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