22 March 2008

WPI: Financial Analysis through December 2007 (Updated)

We previously posted an analysis of Watson Pharmaceuticals' (WPI) preliminary report on the quarter and year that ended 31 December 2007. The initial report, as is typically the case for Watson, didn't include a full Balance Sheet. Details characterizing inventories, current liabilities, and stockholder's equity were missing. These omissions, however, did not prevent us from estimating GCFR gauge scores.

A full set of financial statements became available when Watson filed a 10-K annual report with the SEC. The additional detail, combined with some adjustments made to the scoring algorithms, pushed up Watson's gauge scores.

Our previous analysis of the quarterly Income Statement did not change.

An Overall gauge score in the 50's would normally, as shown in the figure, be a cause for optimism about the potential for future gains in Watson's share price. In this case, we have to be extra cautious because the acquisition of Andrx Corporation in the fourth quarter of 2006, for $1.9 billion in cash, distorts year-to-year comparisons. The company took an enormous $500 million charge for in-process R&D in the immediate aftermath of the acquisition. To a certain extent, Watson's current results appear rosier simply because 2007 did not include a similar cash expenditure and associated write-off.

The Cash Management gauge would have been higher if not for two Inventory metrics. Inventory/CGS rose over the last year from 118 to 122 days, and the ratio of Finished Goods to Total Inventory soared from 65 percent to 70 percent Increases in these ratios can hint that a company's products sold at a slower pace than expected. If this is the case, the company might then have to cut production or take back unsold goods from wholesalers.

The Profitability gauge score rose primarily because of the Accrual Ratio. This measure of earnings quality improved because cash used for investments was so much less in 2007, as mentioned above.

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