25 June 2008

WPI: Look Ahead to June 2008 Results

When we analyzed the first-quarter finances of Watson Pharmaceuticals, the Overall Gauge score decreased to 47 of 100 possible points. The score was a more robust 56 points three months earlier. Revenue was 6.6 percent less than in the year-earlier quarter, perhaps because of the termination of a product distribution agreement.

One of our concerns was that the company held 127 days of Inventory, as measured by the Cost of Goods Sold, up from 122 days in December 2007 and 102 days in March 2007. Seventy percent of the Inventory was Finished Goods, a slight increase from three months earlier and up significantly from 62.2 percent 12 months ago. Expanding Inventory can signal that the company's products are selling slower than expected. An alternative explanation, one with more positive implications, is that the company might be getting ready to launch a new product.

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 late 2006 reversed this strategy, and generics are now responsible for three times as much Revenue as branded products. Watson's management may have deliberately increased their generic drug exposure to take advantage of the large number of branded pharmaceutical products that have, or will soon, lose their patent protection.

The Andrx acquisition, for $1.9 billion in cash, distorted year-to-year comparisons throughout 2007. However, this big purchase is now fading into the rear-view mirror, and we should be able to get a better handle on Watson's finances.

On 31 July 2008, Watson is scheduled to announce its results for the nearly concluded second quarter. In anticipation of this report, we've modeled the company's Income Statement for the quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

Watson's announcement of its first-quarter results included an update of company management's outlook for 2008.

For the top-line, management estimated that Revenue in 2008 would be approximately $2.5 billion, which would represent zero growth over 2007. Revenue was about $627 million -- remarkably close to 25 percent of the expect annual total -- in both 2007's fourth quarter and 2008's first quarter. We will, to use a rounder number, assume Revenue in the second quarter will increase ever so slightly to $630 million.

The company didn't provide a forecast for Gross Margin. We will assume the margin will match its 40.5-percent average over the previous four quarters. Therefore, our estimate for the Cost of Goods Sold in the second quarter is (1 - 0.405) * $630 million, which equals $375 million.

Watson stated that 2008's Amortization expense is expected to be $80 million. In the first quarter, this expense was right on track at $20.2 million. We will look for another $20 million in the second quarter.

The company forecast Research and Development expenses for 2008 at $160 million. (Previous guidance was $160 to $170 million.) The first-quarter value was slightly below the trend line at $38 million. We will look for $40 million of R&D in the first quarter.

Watson also predicted this year's Sales, General, and Administrative expenses to be between $420 to $440 million. The first-quarter expense was on track at $107 million. We will set the second quarter target for SG&A at $110 million.

These estimates would result in an Operating Income of $85 million, up 29 percent from $66 million in the June 2007 quarter.

Watson's non-operating income and expenses are typically minor. Lacking specific guidance, we'll assume a $4 million net expense. This would lead to Income before Taxes of $81 million.

With a 37 percent Income Tax Rate, Net Income will be $51 million ($0.44/share) for the quarter. This is consistent with Watson's guidance for GAAP earnings in 2008 to be between $1.70 to $1.80 ($0.02 above previous guidance on both sides) per diluted share. Our estimate is 40 percent above Net Income in 2007's second quarter.

Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

($ M)

June 2008
June 2007

Op expenses

CGS (375)


R&D (40)

SG&A (110) (97)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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