14 December 2008

WPI: Look Ahead to December 2008 Quarterly Results

The GCFR Overall Gauge of Watson Pharmaceuticals, Inc. (NYSE: WPI) slipped from 55 of the 100 possible points to 53 in the third quarter of 2008, which ended on 30 September. Our initial and updated analysis reports explained the score in some detail.

Of the four individual gauges that drive the composite score, Profitability was strongest at 17 points, and Growth was weakest at 2 points. In both cases, the top score for the gauge is 25 points. The contrarian Value gauge would have attained a score substantially higher than 14 of 25 points if we had made the calculations with the fourth quarter's much lower share price.

Net Income in the third quarter more than doubled. While growing Revenue certainly helped, a large amount of this improvement can be explained by the resolution of a tax audit and by a gain of $8.25 million on the sale of Watson's 50-percent interest in Somerset Pharmaceuticals to Mylan Labs (NYSE: MYL).

Watson's Inventory-to-Cost of Goods Sold ratio has increased in some recent quarters. The ratio is much lower than it was several years ago, but the uptrend could be a concern. Our unease is magnified because the "Finished Goods" Inventory component has also risen. In the worst case, this could signify lower-then-expected sales. On the other hand, the company indicated it was holding some inventory for products that hadn't been launched as of 30 September. When the new products enter the marketplace, and at least one has, the Inventory level should come down.

For example, on 26 November 2008, Watson announced that it would immediately begin selling a generic equivalent to GlaxoSmithKline's (NYSE: GSK) Wellbutrin XL® product. The U.S. FDA had just approved the company's application to distribute this item, which is indicated for the treatment of major depressive disorder.

To look ahead, we've modeled Watson's Income Statement for the December 2008 quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data that the company will announce on, or about, 18 February 2009. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

Watson Pharmaceuticals, Inc. (NYSE: WPI) develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products. As a result of Watson's acquisition of Andrx in late 2006, 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.

Watson recently agreed to acquire 17 generic drugs, 15 of which have U.S. FDA approvals, that are being divested as a result of the proposed merger between Teva Pharmaceutical Industries Ltd (NASDAQ: TEVA) and Barr Pharmaceuticals, Inc. (NYSE: BRL). The deal is contingent on the merger's consummation, which has been delayed by the antitrust concerns that sparked the sale to Watson.

When the company announced its third-quarter results, it also revised its guidance for the full year.

One number that didn't change was management's estimate that Revenue in 2008 would be approximately $2.5 billion. This figure represents zero growth over Revenue in 2007. Revenue in the first three quarters of 2008 was $1.89 billion, which implies that the guidance for the fourth quarter is $610 million. However, given recent product approvals, our target for fourth-quarter Revenue is $635 million.

The company didn't provide a forecast for Gross Margin. We will, after looking at historical data, assume Watson will achieve a margin equal to 40 percent of Revenue. Therefore, our estimate for the Cost of Goods Sold (CGS) in the fourth quarter is (1 - 0.40) * $635 million, which equals $381 million.

Watson stated that 2008's Amortization expense is expected to be $80 million. In each of the first three quarters of the year, this expense was $20.2 million. We, therefore, believe the fourth quarter value will be another $20.2 million, or nearly so.

The company forecast Research and Development expenses for 2008 at $160 million. These expenses were $122.6 million through September, just slightly more than three-quarters of the year's forecast. We will look for $40 million of R&D in the fourth quarter.

Watson also predicted this year's Sales, General, and Administrative expenses will be between $420 to $430 million. In the first three quarters, SG&A expenses were $312.2 million. This leaves about $113 million for the fourth quarter, if we set the annual target at the middle of the guidance range.

These estimates would result in an Operating Income of $80.8 million, up 22.6 percent from the December 2007 quarter.

Watson's non-operating income and expenses are typically minor (last quarter was an exception). Lacking specific guidance, we'll assume a $2 million net expense. This would lead to Income before Taxes of $78.8 million.

With a 36 percent Income Tax Rate, Net Income will be $50.4 million ($0.43/share) for the quarter. Our estimate is 31 percent above Net Income in 2007's fourth 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)

December 2008
December 2007

Op expenses

CGS (381.0)


R&D (40.0)

SG&A (113.0) (108.3)

Operating Income
Other income


Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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