27 December 2008

WMT: Look Ahead to January 2009 Quarterly Results

2009 is about to begin for most of us, but fiscal 2009 will end on 31 January for Wal-Mart and many other retailers.  Wal-Mart will announce its fourth quarter and full year results on 17 February 2009.

This post explains how we modeled Wal-Mart's Income Statement for the January quarter.  When the actual results are published, we will compare them to the model to identify the extent to which sales, expenses and other gains/losses differed from our expectations.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

We will get much-needed opportunities to refine the model when Wal-Mart reports monthly sales data for December 2008 and January 2009.


Discounter Wal-Mart Stores, Inc. (NYSE: WMT) had sales of $400 billion, nearly 10 percent of U.S. retail sales, in the last 12 months.  It garnered the top spot on the 2008 edition of the Fortune 500 list of America's largest corporations, edging ahead of Exxon Mobil (NYSE: XOM). 

Mike Duke, vice chairman of Wal-Mart International, will take over as CEO from Lee Scott on 1 February 2009.  He will grab the reins when retails everywhere are struggling.  Holiday sales were down, and one corporate adviser that tracks these sorts of things has warned that many large retailers "are at significant risk of filing for bankruptcy or facing financial distress in 2009 or 2010."

Wal-Mart, on the other hand, sells the merchandise shoppers can't do without, even during tough times.  Efficient operations allow Wal-Mart to keep prices at levels too low for competitors, such as Target (NYSE: TGT), Kohl's (NYSE: KSS), and Sears Holdings (NASDAQ: SHLD), to match. 

The company certainly has its share of critics, some of whom have commented on GCFR analyses.

Wal-Mart announced on 23 December 2008 the settlement of 63 wage and hour class action lawsuits.  The agreement will cost the company between $352 million and $640 million.  It will account for this obligation by recording an after-tax charge of approximately $250 million in the January 2009 quarter.




In the third quarter of fiscal 2009, which ended October 2008, the GCFR Overall Gauge of Wal-Mart slipped from 32 to 27 of the 100 possible points.  Our initial and updated analysis reports explained the score in some detail.

Earnings in the third quarter were a little better than we expected.  However, three of our four component gauges fell as momentum from the strong July quarter waned.  Since Wal-Mart is better insulated from the credit crisis and the ensuing economic decline than most firms, its share price is actually higher now than it was 12 months ago.  As a result, our contrarian Value gauge for Wal-Mart, which tends to move in the opposite direction of the share price, hasn't jumped like it has for so many other companies.


When the third quarter results were announced, Wal-Mart provided the following guidance for the fourth quarter and fiscal year:

For the fourth quarter of fiscal year 2009, the Company estimates the comparable store sales increase in the United States to be between one and three percent, according to Tom Schoewe, Wal-Mart Stores, Inc. executive vice president and chief financial officer.

“We estimate diluted earnings per share from continuing operations for the fourth quarter will be between $1.03 and $1.07,” Schoewe said. “The rapid changes in currency exchange rates during the last few weeks are projected to negatively affect this year’s fourth-quarter results by approximately six cents per share. In U.S. dollar terms, strong operating performance in International may be overshadowed by these currency fluctuations.

“For the full year, ending January 31, we have tightened and modestly reduced our guidance and now forecast diluted earnings per share from continuing operations to be within a range of $3.42 to $3.46,” he said.


Note that the guidance related to Revenue is limited to comparable sales (sometimes called same-store sales) in the U.S.  For international sales (about 25 percent of the company's business), the guidance is silent on Revenue, but it provides an estimate of how much the strengthening U.S. currency will cut into earnings, which are expressed in dollars.

In November, Wal-Mart's U.S. Net Sales were up 5.7 percent, but international sales were down by 11 percent.  The brisk rise in the U.S. dollar reduced Wal-Mart's international sales by 18.7 percent.

Until the economic and currency situation becomes clearer, we're going use November's overall growth in Net Sales, 1.6 percent, as a proxy for the entire quarter.  Since Revenue in the January 2008 quarter was $106.3 billion, this sets our target for the current quarter at $108.0 billion.

Wal-Mart's Gross Margin has been 23.7 percent in the last four quarters.  Additional discounting in the January quarter would be normal, so we expect the margin to be about 23.5 percent in the current period.  With this assumption, our estimate for Cost of Goods Sold (CGS) is (1 - 0.235) * $108 billion = $82.6 billion.

Sales, General, and Administrative (SG&A) expenses are typically around 19 percent of Revenue, but they are usually less proportionately in the high-Sales January period.  Our estimate for the current quarter is 18 percent.  Therefore, we expect this expense to be 0.18 * $108 billion = $19.4 billion.

Until more specific accounting guidance is offered, we will assume the settlement charge will be recorded as a special operating expense.  Given typical tax rates, the pre-tax amount will be about $385 million to result in an after-tax value of approximately $250 million.

These expense estimates would lead to an Operating Income of $5.55 billion, which would be down 3 percent from the January 2008 quarter.

We will assume, based on the recent history, a deduction for Minority interests of $125 million.  Similarly, historical data are the basis for our $575 million estimate for Net Interest and other income.  These non-operating values set our estimate for pre-tax income to $6.0 billion.

If we project an Income Tax Rate of 35 percent, the provision for income taxes would be $2.1 billion and Net Income would be $3.9 billion ($0.99 per share).  If these figures are true, Net Income will be 4.7 percent below that in year-earlier quarter. 

It is important to note that our estimate includes the class-action settlement charge, which was not an element of the company's guidance.  If we back out the charges, our estimate of Net Income rises to $4.15 billion ($1.05 per share).  This happens to be right in the middle of the company's guidance.

Please note that the tabular format in the embedded spreadsheet, 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.

24 December 2008

NVDA: Look Ahead to January 2009 Quarterly Results

Fiscal 2009 for NVIDIA will come to an end on 25 January. The company will announce its fourth quarter and full year results in early February.

This post explains our model of NVIDIA's Income Statement for the January quarter. We will use this baseline for identifying sales and expense items where the actual results differed from our expectations. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.


NVIDIA Corporation (NASDAQ: NVDA), based in Santa Clara, CA, builds a variety of specialized Graphics Processing Units. These devices perform computationally intense tasks required to produce realistic images for video games and other applications. This Specialized Semiconductor company, which had its initial public offering in 1999, competes with firms such as Intel Corporation (NASDAQ: INTC) and Advanced Micro Devices (NYSE: AMD).

In October, Apple, Inc., (NASDAQ: AAPL) decided to increase its use of NVIDIA's chips. Steve Jobs is reported to have said this "change speeds up processing-intensive activities—playing popular 3-D video games, for example—as much as six-fold." Apple made this choice despite indications faulty NVIDIA chips were the cause of odd video problems in MacBook Pro laptops.

Earlier this year, NVIDIA recorded a $196 million charge to cover warranty, replacement, and other costs related to faults in certain products for notebook computers. The faults are said to result from "a weak die/packaging material set" that is no longer used. It's not clear that this amount will be sufficient when lawsuits are considered. However, insurance might defray part of the bill.

NVIDIA has also had to deal with reduced sales of GPUs for desktop computers, a condition they attributed to a "miscalculation of competitive price position." Not surprisingly, NVIDIA's missteps have been reflected in the company's share price, which is now 75 percent below the 52-week high. In an effort to reverse the decline, the company added $1 billion to its stock repurchase program.



In the third quarter of fiscal 2009, which ended on 26 October 2008, the GCFR Overall Gauge of NVIDIA decreased from 65 to 53 of the 100 possible points. Our initial and updated analysis reports explained the score in some detail.

The contrarian Value gauge reacted to plunging share price by hitting its 25-point maximum score. However, the Growth and Profitability gauges were mired in low-single-digit territory.


When NVIDIA conducted a conference call to discuss October's results, according to a SeekingAlpha transcript, Chief Financial Officer Marv Burkett indicated that fourth quarter Revenue could be down by 5 percent, plus or minus some wide, but unspecified, range. He attributed the uncertainty to changing economic conditions. It wasn't clear from the transcript whether Burkett meant a 5 percent drop from the previous quarter in the sequence or a 5 percent drop from the year-earlier quarter. The difference is immense: Revenue in the October 2008 quarter was $898 million and Revenue in the January 2008 quarter was $1.203 billion.

The 10-Q makes the Revenue guidance a little clearer, although a percentage rate was omitted. The 10-Q states: "We expect revenue to decline slightly during the fourth quarter of fiscal year 2009 as compared to the third quarter of fiscal year 2009."

A reasonable start at determining a Revenue target for the January 2009 quarter is to trim five percent from the $898 million in the October 2008. This figure is $853 million. However, given the weak sales data previously made available by other semiconductor manufacturers, this might be somewhat optimistic. One analyst estimated Revenue as low as $790 million. We set our target by changing the 5 percent drop to 7 percent, which yields $835 million.


Management's guidance for Gross Margin in the January quarter is 41 percent. Although we suspect there will pressure on margin in this period of slow sales, we're going to stick with the announced percentage. In other words, we expect to see Cost of Goods Sold (CGS) is (1 - 0.41) * $835 million, which is $493 million.

NVIDIA told investors to expect the quarter's Operating Expenses, by which they mean Research and Development and Sales, General, and Administrative costs, to be about $310 million. We hope management became more aggressive about cost cutting when sales started to slow by a greater amount than initially forecast. We think they can get to $295 million, which we have allocated as $210 million for R&D and the remaining $85 million for SG&A.

The company stated that restructuring charges would be $0.8 million in the fourth quarter, and we will assume no asset impairment charges.

These figures would result in Operating Income, as we define it, of $47 million. This result is 82 percent below the comparable year-earlier value.

For Interest and other non-operating income, our estimate is $10 million.

NVIDIA estimated that its tax rate in the current quarter would be about 13 percent. This rate would yield a Net Income of $49 million ($0.09 per share), compared to $257 million ($0.42 per share) in the January 2008 quarter.

Please note that the tabular 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)

January 2009
(predicted)
January 2008
(actual)
Revenue

835
1,203
Op expenses




CGS (1) (493)
(653)

R&D (210)
(196)

SG&A
(85)
(91)

Other (2)
(1)
(0)
Operating Income
47
262
Other income




Investments
0
0

Interest, etc. (3)
10
17
Pretax income

57
280
Income tax

(7)
(23)
Net Income
(49)
257


$0.09/sh
$0.42/sh
Shares outstanding

560
609
(1) Cost of Revenue
(2) Repair and replacement costs.
(3) interest and other income (expense)

21 December 2008

CSCO: Look Ahead to January 2009 Quarterly Results

The second quarter of Cisco Systems' fiscal 2009 will end on 24 January, and the company will report its results in early February.

This post describes a model of the Income Statement for the quarter. The model serves as a baseline for identifying and assessing deviations, positive or negative, from the expected in the actual data. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.


Cisco Systems, Inc. (NASDAQ: CSCO), the proud plumber of the Internet, has a commanding position in the market for enterprise networking products and services, such as routers. After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use.

In the first quarter of fiscal 2009, which ended on 25 October 2008, the GCFR Overall Gauge of Cisco increased from 61 to 64 of the 100 possible points. Our initial and updated analysis reports explained the score in some detail.

The rising score was primarily the result of the Value gauge strengthening from 16 to 20 of the 25 possible points. The contrarian Value gauge tends to move in the opposite direction of the share price, and the stock market crash of 2008 has cut deeply into equity prices. The effects of the slowing worldwide economy were seen Cisco's falling Revenue, Cash Flow, and Net Income growth rates, which squeezed the Growth gauge down to a mere 2 of the 25 possible points.



In response to declining sales, Cisco Systems announced in late November that it would cut costs by closing its North American units for 5 days around New Years Day.

Leaders at Cisco often express confidence that the company's Revenue can expand over the long term at a rate between 12 and 17 percent. As recently as 3 December 2008, CEO John Chambers was quoted by Reuters as saying: "We're very comfortable, with the appropriate normal economic conditions, of growing our business in the 12 to 17 percent range." The company adds caveats indicating that Revenue in some quarters will be above or below this range.

In fact, Cisco's guidance for Revenue in the January quarter is "for revenue to decrease in the 5 to 10% range year over year." This quote is taken from the Seeking Alpha transcript of Cisco's conference call on 5 November 2008. [The GCFR definition of "year-over-year" is "the last four quarters compared to the four previous quarters." We learned the hard way that Cisco's alternative definition is "this quarter compared to the year-earlier quarter."]

Our target for the Revenue in the January 2009 quarter is $9.04 billion. This amount was determined by trimming 8 percent from the $9.83 billion figure for sales in the quarter that ended 26 January 2008. The target value is about 12.5 percent less than Revenue in the October 2008 quarter.

Management's guidance for Gross Margin in the January quarter is 64 percent. We're going to be a slightly more conservative and use 63.75 percent. In other words, our forecast for Cost of Goods Sold (CGS) is (1 - 0.6375) * $9.04 billion, which is $3.3 billion.

Cisco expects the quarter's Operating Expenses to be between 39 and 41 percent of Revenue. Operating Expenses, as Cisco defines the term, include Research and Development and Sales, General, and Administrative costs. [On GCFR Income Statements, CGS is also listed as an Operating Expense.] The guidance implies that Cisco expects the sum of R&D and SG&A costs to be between $3.5 billion and $3.7 billion. We're going to assume the higher figure because Cisco's guidance typically refers to non-GAAP results that exclude costs we track. Given past results, we have apportioned the $3.7 billion as $1.25 billion for R&D and $2.45 billion for SG&A.

Cisco always reports various other operating charges, including payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and the mysterious in-process research and development. The average value for these charges in the last 10 quarters, discarding the highest and lowest values, is $126 million.

These figures would result in Operating Income, as we define it, of $1.94 billion. This result is 19.3 percent below the comparable year-earlier value.

Cisco indicated that Interest and Other Income would be about $130 million in the January quarter. This is $100 million less than the equivalent figure in January 2008 quarter.

Pretax income would, therefore, be about $2.1 billion. Management forecasts a 22 percent Income Tax Rate, which would lead to Provisions for Income Taxes of $455 million.

Given all of the following, it's should be clear why we're looking to see GAAP Net Income in the quarter equal to $1.6 billion (about $0.27 per share), which is 21.6 percent below earnings of the year-earlier quarter.

Please note that the tabular 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)

January 2009
(predicted)
January 2008
(actual)
Revenue
9,045 9,831
Op expenses




CGS (3,279)
(3,491)

R&D (1,250)
(1,216)

SG&A (2,450)
(2,604)

Other (126)
(116)
Operating Income
1,940 2,404
Other income




Investments
0
0

Interest, etc.
130 234
Pretax income

2,070 2,638
Income tax

(455)
(578)
Net Income
1,615 2,060


$0.27/sh
$0.33/sh
Shares outstanding

5,950
6,202

20 December 2008

NT: Look Ahead to December 2008 Quarterly Results

The GCFR Overall Gauge of Nortel Networks (NYSE: NT) registered 35 of the 100 possible points in the third quarter of 2008, which ended on 30 September.  Our analysis report explained the score in some detail.

While 35 points is not an especially good score, the number is clearly much too high given Nortel's diminished financial stature and future prospects.  The GCFR gauges produce inflated results, as we've seen with Nortel, when evaluating a company with Net Losses, negative Cash Flow from Operations, and massive "special" charges.  We've made some minor adjustments to the underlying algorithms to correct the problem, but we're proceeding cautiously.  We want to the gauges to retain sufficient sensitivity to detect the early signs of a turnaround in a troubled company.


The September 2008 quarter included a $1.1 billion, non-cash charge for "Goodwill Impairment."  To add salt to the wound, negative pretax income was accompanied by a jaw-dropping $2.2 billion Provision for Income Taxes.  The bottom-line Net Loss was $3.4 billion.  The tax situation is complicated, but Nortel reported "it will not be able to use all of its net deferred tax assets within a reasonable timeframe."

We've wondered, in jest, if Nortel's raison d'ĂȘtre is to pay income taxes on non-existent profits.  In the last 10 quarters, tax provisions were $3.375 billion on a cumulative pretax loss of $1.285 billion.




On 11 December 2008, the NYSE notified Nortel that the persistent share price below $1.00 violates one of the exchange's listing standards.  It was, amazingly enough, only two years ago that Nortel implemented a 1-for-10 reverse stock split to boost the share price.  Nortel has 6 months to rectify the current problem.  However, a bankruptcy filing, which is under consideration, would render the listing qualifications moot. 


To look ahead, we've modeled Nortel'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 in late February 2009.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.


First, we will take a step back.

Nortel Networks Corp. (NYSE: NT) is the Canadian-based supplier of products and services to telecom carriers, other networking enterprises, and businesses.   Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated deficit (i.e., negative retained earnings) of $40 billion (U.S.).

Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of misdeeds.  The RCMP charged a former Nortel CEO and two other executives with fraud for errors for errors in the company's financial statements. 

Nortel, on 17 September 2008, announced that sales in certain markets were under "significant pressure."  The warning was accompanied by an announcement that the company intends "to explore a divestiture of its Metro Ethernet Networks (MEN) business," which it refers to as "a premium asset."


When it announced third quarter results, Nortel also updated its outlook for the full year of 2008.

Nortel [the company stated] revised its revenue and management operating margin financial outlook for the full year 2008 to around the low end of the previously announced ranges primarily due to the further deteriorating economic conditions and the unfavourable impact of foreign exchange and now expects revenue to decline by around four percent compared to 2007 (versus the previous range of a decline of two to four percent), gross margin to be about 42 percent of revenue, and management operating margin(a) to improve about 125 basis points compared to 2007 (versus the previous range of an improvement of 125 to 175 basis points). In light of the economic conditions noted above, and continuing foreign exchange volatility, Nortel’s actual results may be lower than these current expectations.

As previously announced, the full year outlook includes the expected completion of wireless contracts in the fourth quarter representing about $320 million of previously deferred revenue. These contracts are progressing towards completion and the Company currently expects to meet the conditions to recognize the previously deferred revenue in the fourth quarter.


Guidance for the fourth quarter can be derived easily from the full year outlook and the reported data for the first nine months of the year.

Nortel's Revenue in 2007 was $10.95 billion.  By trimming four percent from this figure, we get management's 2008 target of $10.5 billion.  Subtracting year-to-date Revenue of $7.7 billion yields guidance for the fourth quarter of $2.8 billion.  The GCFR target is $2.75 billion because we suspect conditions worsened over the course of the quarter.

For the Gross Margin to be 42 percent for the full year, in accordance with the guidance, the Cost of Goods Sold during the year would have to be (1 - 0.42) * $10.5 billion = $6.1 billion.  CGS in the first three quarters was about $4.5 billion, which leaves $1.5 billion for the fourth quarter.  Our precise target is $1.545 billion.

In 2007, Operating Expenses (CGS + R&D + SG&A) were 96.34 percent of Revenue.  Management indicated that the equivalent figure for 2008 would be about 1.25 percent less, or 95.1 percent.  Using our Revenue and CGS estimates, it can easily be determined that Research and Development and Sales, General, and Administrative in the fourth quarter would have to sum to no more than $950 million to achieve the 95.1 percent implied guidance.  For the record, we have allocated $400 million of the $950 million to R&D and the remaining $550 million to SG&A.

Nortel's quarterly results usually include other operating expenses such as Amortization of Intangibles, In-process R&D, and Special Charges.  These items were not mentioned in the company's guidance, and the figures fluctuate so much from quarter to quarter that we can't predict them with any confidence.  We made our $66 million estimate by taking the average charge over the last 10 quarters, ignoring the highest and lowest values.

The Revenue and expense numbers identified above would lead to an Operating Income, as we define it, of $189 million in the quarter.  This value is 5 percent less than in the comparable year-earlier quarter.

Gains and losses from Non-operating activities (minority interests, equity in associated companies, asset sales, an interest expense) are also volatile from quarter to quarter.  If (as above) we take 10-quarter average values for these figures, but throw out the high and low values, the total expected non-operating expense is $50 million.

This assumption results in pretax income at $139 million.

Nortel's quarterly effective income tax rate defies prediction.  For example, in the December 2007 quarter, Nortel recorded a non-cash charge over $1 billion to increase the valuation allowance associated with Canadian deferred tax assets.  This tax charge turned a modest gain into a huge loss.

Admitting our inability to make sense of Nortel's tax situation, we have arbitrarily assumed a +30 percent tax rate for the fourth quarter. 

This would yield Net Income of $97 million ($0.19 per share), compared to a loss of $844 million in the December 2007 quarter.  Given the number of substantial estimates we had to make to come up with the income projection, our confidence in it is not very high.

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
(predicted)
December 2007
(actual)
Revenue (1) 2,750 3,198
Operating expenses
CGS (1,545) (1,801)
R&D (400) (475)
SG&A (550) (678)
Other (2) (66)
(45)
Operating
Income
189 199
Other income
Investments (3) (32) (39)
Asset sales723
Interest, etc. (4) (25) 13
Pretax income 139 196
Income tax (42) (1,040)
Net Income 97 (844)
$0.19/sh ($1.69)/sh
Shares outstanding 500 498
1. Total revenues include products and services.
2. Amortization of intangible assets + Special charges + In-process R&D
3. Minority interests + Equity in net income of associated companies. Both figures are net of tax.
4. Other income - Interest expense

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
(predicted)
December 2007
(actual)
Revenue

635.0
627.3
Op expenses




CGS (381.0)
(373.2)

Depreciation
(20.2)
(44.2)

R&D (40.0)
(35.8)

SG&A (113.0) (108.3)

Other
(0)
(0)
Operating Income
80.8
65.9
Other income




Investments
0
0

Interest, etc.
(2.0)
(6.1)
Pretax income

78.8
59.8
Income tax

(28.4)
(21.4)
Net Income
50.4
38.4


$0.43/sh
$0.33/sh
Shares outstanding

118.0
117.4

13 December 2008

KG: Look Ahead to December 2008 Quarterly Results

The GCFR Overall Gauge of King Pharmaceuticals (NYSE: KG) increased from 54 to 68 of the 100 possible points in the third quarter of 2008, which ended on 30 September. Our analysis report explained this score in some detail.

Despite Revenue in the third quarter falling almost 30 percent, the score rose because operating expenses were slashed by a greater amount. The sinking price per share also made the valuation appear more attractive.


To look ahead, we've modeled King'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, 6 February 2009. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.


King Pharmaceuticals, Inc. (NYSE: KG) manufactures and sells various brand-name prescription pharmaceuticals. Headquartered in Bristol, TN, King now focuses on specialty products for the neuroscience, hospital and acute care markets.

Last month, Alpharma, Inc. (NYSE: ALO) accepted King's tender offer to purchase all Alpharma common shares for $37 per share in cash -- about $1.6 billion in total. Alpharma will become a wholly owned subsidiary of King. Alpharma's KADIAN and FLECTOR products for treating acute pain appealed to King, which is looking to increase its share of the pain-care market.

King must have been bitterly disappointed when, earlier this month, the U.S. FDA asked for additional non-clinical data on the abuse-resistant painkiller REMOXY King is developing with Pain Therapeutics, Inc. (NASDAQ: PTIE).

In 2007, the U.S. Court of Appeals invalidated King's patent for Altace® (Ramipril). This ACE inhibitor, used to treat patients with cardiovascular risks, had accounted for roughly 1/3 of King's net sales. The Court's decision resulted in King recognizing asset impairment charges (covering intangible assets and inventory) totaling $250 million and King laying off 20 percent of its staff.

During the first few quarters after the Altace decision, before its negative consequences really took hold, the GCFR gauges of King's performance went haywire and misleadingly indicated that King shares were significantly undervalued. It was during this period that the Overall gauge soared to 75 points, normally a superlative score. It took until the second quarter of 2008, when generic Ramipril became available from firms other than Cobalt Laboratories, for our gauges to move towards a more realistic assessment of King.


Readers are advised to read the transcript at SeekingAlpha.com from King's conference call with financial analysts on 6 November 2008.

We expect Revenue in the fourth quarter to be down 30 percent from that in the December 2007 quarter. Given that Revenue in the earlier period was $533 million, this sets our target for the current quarter at $373 million.

Management reiterated last month that they expect the Gross Margin for the year to be 75 percent. Since the margin in the first three quarters of 2008 was 75.8 percent, we assume it might be a little less than the guidance value in the fourth quarter. If we set the fourth-quarter target at 74 percent, and apply our Revenue estimate, the Cost of Goods Sold (CGS) should be about (1 - 0.74) * $373 million = $101 million.

The company was clear in May that it expects quarterly expenses for Depreciation and Amortization to be about $31 million.

In November, management indicated that Research and Development expenses in 2008 will match 2007's $150 million value. If we subtract the $111 million of R&D during the first nine months of the current year, we get an R&D estimate for the December quarter of $39 million.

In 2008 to date, Sales, General, and Administrative expenses have been about 28 percent of Revenue, which ought to be a good estimate for the fourth quarter. Given our $373 million Revenue projection, our SG&A target for the fourth quarter is $105 million.

King often announces non-recurring operating charges. Costs associated with the Alpharma acquisition would fall into this category. We don't have sufficient insights to forecast these charges, which can greatly influence overall GAAP earnings, with any confidence. Our $44 million fourth-quarter estimate is the average charge for the last 10 quarters, ignoring the highest and lowest values.

The estimates above would lead to an Operating Income for the quarter of $58 million, which is 18 percent more than the comparable value in 2007's fourth quarter.

Net Non-Operating Income or (Expense) is usually around $5 to $10 million per quarter. We chose to use the lower value of this range for the fourth quarter estimate.

If the Income Tax Rate matches the 34 percent rate during the first three quarters of the year, Net Income will be $41 million ($0.17 per share). This is about 3 percent less than in the year-earlier 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
(predicted)
December 2007
(actual)
Revenue

373
533
Op expenses




CGS (97)
(109)

Depreciation
(31)
(61)

R&D (39)
(45)

SG&A (105) (164)

Other
(44)
(104)
Operating Income
58
49
Other income




Investments
0
0

Interest, etc.
5
12
Pretax income

63
61
Income tax

(21)
(18)
Net Income
41
43


$0.17/sh
$0.18/sh
Shares outstanding

245
244