21 February 2009

WPI: Financial Analysis through December 2008

Watson Pharmaceuticals recently announced earnings for the quarter that ended on 31 December 2008.  This post provides the GCFR analysis for this period, which was the fourth quarter of the fiscal year.

To update the GCFR gauges, we had to make a few assumptions because the Balance Sheet in Watson's press release omitted some details, including those characterizing inventory, current liabilities, and stockholder's equity.  We will recompute the gauge scores when complete financial statements and notes become available in the company's 10-K filing.

Watson Pharmaceuticals, Inc. (NYSE: WPI) develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products.  Watson also distributes products made by other companies.
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 purchased the rights to 15 drugs that were divested, to resolve antitrust concerns, when Teva Pharmaceutical Industries Ltd (NASDAQ: TEVA) acquired Barr Pharmaceuticals, Inc. (NYSE: BRL).

Three months ago, the GCFR Overall Gauge of Watson Pharmaceuticals slipped a couple of points, to 57 of the 100 possible points.  Our initial and updated analysis reports on the third quarter of 2008 explained the score in some detail.

Of the four individual gauges that drive the composite score, Profitability was strongest and Growth was weakest in the September quarter.

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).

Now, with the available data for the December quarter, our gauges display the following scores:

  • Overall: 56 of 100 (down from 57)

Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.

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.


Watson's Revenue in the quarter was 2.9 percent more than in the year-earlier quarter.  While this growth rate might seem a little tepid, Revenue was actually a little higher, 1.6 percent to be specific, than our $635 million target.  Revenue for the full year was $2.54 billion, up 1.6 percent from 2007.  The annual results were consistent with management's guidance.

The Distribution segment exhibited the greatest Revenue growth, at 13 percent, in the fourth quarter.  The robust rate was attributed to new product launches. 

The Cost of Goods Sold was 58.3 percent of Revenue, which translates into a Gross Margin of 41.7 percent.  The actual margin in the fourth quarter was more profitable than the 40.0 percent we expected and also the 40.5 percent Gross Margin in the December 2007 quarter.  The increase is probably because generics were a smaller proportion of the product mix.

Depreciation and Amortization was slightly less than our $20.2 million target.  For the year, Depreciation and Amortization totaled $80.7 million, just a little bit more than the company's $80 million guidance.

The company spent 7.4 percent of Revenue on Research and Development (R&D).  The expense was a rather substantial 19 percent more than our prediction, which was based on Watson's guidance to expect R&D expenses of $160 million in 2008.  The company actually invested $170 million on R&D in 2008.

Sales, General, and Administrative (SG&A) costs were 17.2 percent of Revenue, compared to our estimate of 17.8 percent and an actual figure of 17.3 percent in the year-earlier period.   For the year, the total SG&A costs of $423 million were consistent with the guidance to expect annual SG&A expenses between $420 to $430 million.

Operating Income was up a very good 36.8 percent from the amount in the December 2007 quarter, but it exceeded our prediction by only 11.5 percent.  The improved performance was the result of better-than-expected Revenue and Gross Margin, offset by higher-than-expected R&D expenses.

Total Non-Operating expenses was $1.5 million more than we expected.

Our target for the Income Tax Rate was 36 percent, and the actual rate was only 34.9 percent.

Net Income was 46.8 percent more than the result of the year-earlier quarter, and it exceeded our prediction by 11.9 percent. 

Cash ManagementDecember 2008
3 months ago12 months ago
Current Ratio3.0
2.0 yrs
2.0 yrs
2.1 yrs
117 days
122 days
122 days
Finished Goods/Inventory
Days of Sales Outstanding (DSO)41.2 days
42.8 days
47.6 days
Working Capital/Market Capitalization  24.6%
Cash Conversion Cycle Time56.7 days
74.3 days
56.9 days
Gauge Score (0 to 25)

The Balance Sheet remains strong; the downward trend in LTD/Equity is welcome.  The decrease in Inventory and the lower Days of Sales Outstanding are also both positive.  Similarly, the steady increases in Working Capital to Market Capitalization might be interesting to Value Investors.

GrowthDecember 20083 months ago12 months ago
Revenue growth1.6%
Revenue/Assets 70.9%
CFO growth
Net Income growth 69.0%
Gauge Score (0 to 25)11
Growth rates are trailing four quarters compared to four previous quarters.

Clearly, it is Net Income, not Revenue nor Cash Flow from Operations, that has perked up the Growth gauge.

ProfitabilityDecember 20083 months ago12 months ago
Operating Expenses/Revenue 85.9%
ROIC 9.9%
Accrual Ratio
Gauge Score (0 to 25)10

Operating expenses as a percentage of Revenue have dropped rather substantially, and ROIC continues to recover from anemic levels.  However, Free Cash Flow to Equity is moving in the opposite direction.  The rise in the Accrual Ratio suggests that Earnings Quality could have degraded a little.  It indicates that less of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, more is due to changes in non-operational Balance Sheet accruals.

ValueDecember 20083 months ago12 months ago
P/E 13.2
P/E to S&P 500 average P/E 81%
Price/Revenue 1.2
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)18

Shares of Watson Pharmaceuticals fell in price during the fourth quarter, from $28.50 to $26.57.  The Value gauge score is calculated using the quarter-end price, in accordance with GCFR standard practice.

We notice immediately that Watson shares were trading last year at a 27 percent premium to the market, but now they are at a 19 percent discount.  We also notice the low Enterprise Value to Cash Flow, which also could be appealing to Value Investors.

Watson's valuation ratios can be compared with other companies in the Generic Drug industry.

OverallDecember 20083 months ago
12 months ago
Gauge Score (0 to 100)56

Watson Pharmaceuticals' Revenue in the fourth quarter didn't grow at a torrid rate, but the increase was consistent with, if not slightly better than, expectations.  The Gross Margin improved, probably because generics were a smaller proportion of the product mix.  These results led to impressive increases in both Operating Income and Net Income.

The Cash Management, Growth, and Value gauges all increased in the fourth quarter, with Growth gauge reacting very positively to improving Net Income.  The Profitability gauge went the other way, despite the improved Gross Margin, because Cash Flow growth was on the tepid side.  This may have been an over-reaction to the cash invested to acquire product rights fromTeva and Barr.

The Overall gauge score has now been above 50 points for five consecutive quarter, which we consider to be an encouraging result.  We look forward to the additional data in the 10-K to hone our findings.

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