21 April 2008

WPI: Look Ahead to 2008 First Quarter Results

Our earlier financial analysis of Watson Pharmaceuticals, performed using 2007's fourth quarter and full year results, indicated that the Overall gauge score jumped to a solid 56 points on a scale of 0 to 100. The Overall score for Watson had been in the mid-30's to low-40's for most of the last several years. The latest scores for the Cash Management, Growth, Profitability, and Value gauges were all between 13 and 15 points. (The maximum score for each individual gauge is 25 points.) The Value gauge, in particular, was boosted by a 16 percent drop in Watson's share price during the fourth quarter. The share price decline continued into the new year, until a bottom was reached in early February.

Watson Pharmaceuticals, Inc. (WPI) develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products. Watson had been expanding beyond generic drugs into higher-margin branded products. However, Watson's acquisition of Andrx in the fourth quarter of 2006 reversed this strategy, and generics became responsible for over 75 percent of Revenues. Watson's management may have taken this action to take advantage of the large number of branded pharmaceutical products that have, or will soon, lose their patent protection. This situation increases the attractiveness of generic drug manufacturers.

The Andrx acquisition, for $1.9 billion in cash, distorts year-to-year comparisons and, therefore, makes Watson another company that requires us to be extra cautious when interpreting the gauge scores. Watson took an enormous $500 million charge for in-process R&D in the immediate aftermath of the acquisition. The results for 2007 appear rosier simply because the year did not include 2006's cash expenditure and write-off.

We've now made estimates for Watson's Income Statement in the first quarter of 2008. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data, which the company will publish on 1 May 2008. Our estimates are derived from trends in the company's historical financial results and guidance provided by company management.

Watson's report on the 2007's fourth quarter described management's outlook for 2008. For the top-line, the company estimated that Revenue in 2008 would be approximately $2.5 billion. Since Revenue in 2007 was $2.497 billion, management (surprisingly) expects zero Revenue growth. While an even distribution of Revenue would be $625 million per quarter, we will set the first quarter target at $600 million to allow for some increases over the course of the year.

The company didn't provide a forecast for Gross Margin. We assume the margin will improve on last year's value by a couple of points to 42 percent of Revenue. Therefore, our estimate for the Cost of Goods Sold (CGS) in the first quarter is (1 - 0.42) * $600 million, which equals $348 million.

The company stated that Amortization expenses are expected to be $80 million for the year. We're puzzled by this forecast because this expense has been $40 to $44 million per quarter, not $20 million. We'll grudgingly use the lower figure as our target, and then check to see if the guidance was mistaken.

Watson forecast Research and Development expenses for 2008 at $160 to $170 million. We will look for $40 million of (R&D) in the first quarter.

Similarly, Watson predicted this year's Sales, General, and Administrative expenses to be between $420 to $440 million. We will set the first quarter target for (SG&A) at $105 million.

The company indicated that it would incur approximately $34 million in costs associated with a plant closure and an additional $8 million for licensing and debt repurchase charges. Since we don't know which quarter will incur these charges, we will add $10 million for special operating charges in the first quarter.

These estimates would result in an Operating Income of $77 million.

Watson's non-operating income and expenses are typically minor. Lacking specific guidance, we'll assume a $6 million net expense. This would lead to Income before Taxes of $71 million.

With a 37 percent Income Tax Rate, Net Income will be $45 million ($0.38/share) for the quarter. This is consistent with Watson's guidance for GAAP earnings in 2008 to be between $1.68 to $1.78 per diluted share.

($ M)

March 2008
March 2007

Op expenses

CGS (348)


R&D (40)

SG&A (105) (103)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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