23 December 2007

WPI: Look Ahead to December 2007 Results

When we analyzed Watson Pharmaceuticals (WPI) after the third-quarter results became available, we noted continued progress consolidating last year's Andrx Corp. acquisition. We expressed some concern that evidence of operational efficiency improvements was becoming harder to find. We were also troubled that Finished Goods/Inventory moved up to 67.1 percent (believed to be a record high for Watson), from 65.5 percent in June, and 52.3 percent in September 2006 (pre-Andrx).

A good fourth quarter could ameliorate our concerns.

Watson included guidance for the full year in their third-quarter report. With this guidance, it's not hard to model the Income Statement for the fourth quarter. The company's top- and bottom-line expectations for the quarter are clear. This is also true for some in-between figures. Where specific guidance wasn't provided for lines on the Income Statement, we tried to fill the gaps with historically grounded estimates.

The recent guidance began with a $2.5 billion estimate for total net Revenue for the full year of 2007. Since Sales in the first three quarters were $1.87 billion, the company must be expecting Revenue of $630 million in the December quarter. Back in February, Watson estimated that Revenue for 2007 would be between $2.5 and $2.6 billion. They subsequently zeroed in on the lower figure.

Watson's Gross Margin has been declining as a percentage of Revenue -- probably a result of more generics in the product mix -- but this ratio rebounded a few points in the last two quarters. If we assume the Gross Margin in the fourth quarter will match the third quarter's 42 percent of Revenue, our estimate for the Cost of Goods Sold (CGS) is 58 percent of $630 million, which equals $366 million.

Depreciation expenses have been running at about 7 percent of Revenue. For the fourth quarter, this would be about $44 million.

Watson forecast Research and Development (R&D) expenses for 2007 at approximately six percent of Revenue. This equates to $150 million over the year. Since R&D expenses in the first three quarters totaled $109 million, the estimate for the fourth quarter is $41 million.

Similarly, Watson approximated the year's Sales, General, and Administrative (SG&A) expenses at 17 percent of annual Revenue, which would be about $425 million. Since SG&A costs in the first nine months of the year were $313 million, these costs should be $112 million in the fourth quarter.

These estimates would result in an Operating Income of $67 million.

Watson's non-operating income and expenses are typically minor. Lacking specific guidance, we'll assume a $7 million net expense. This would lead to Income before Income Taxes of $60 million.

With a 37 percent Income Tax Rate, Net Income will be $38 million ($0.33/share) for the quarter and $141 million ($1.20/share) for the year. This is consistent with Watson's guidance for Earnings per Share in 2007 between $1.30 and $1.33. The difference in the figures is a consequence of the company excluding from their estimate approximately $19 million ($12 million net of tax, or $0.10 per diluted share) of acquisition, litigation and impairment charges and certain other gains and losses.

Note that the quarter-to-quarter comparison below is skewed by the $500 million charge in the fourth quarter of 2006 for in-process R&D associated with the Andrx acquisition.

($ M)

Dec 2007
Dec 2006

Op expenses

CGS (366)


R&D (41)

SG&A (112) (102)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income


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