02 May 2009

WPI: Financial Analysis through March 2009

Watson Pharmaceuticals (NYSE: WPI) announced earnings, and filed a 10-Q report, for the three months that ended on 31 March 2009.  This post provides the GCFR analysis for this period.

The Balance Sheet in the 10-Q is more complete than the one in Watson's press release.

First, we present some background information.

Watson Pharmaceuticals, Inc., develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products.  Sales of generic drugs accounted for 58 percent of Watson's total Revenue in 2008. 

The company became one of the top generic drug manufacturers, along with Teva Pharmaceutical (NASDAQ: TEVA) and Mylan (NYSE: MYL), when it acquired Andrx in late 2006.  This growth continued more recently when Watson purchased the rights to 15 drugs that were divested, to resolve antitrust concerns, after Teva acquired Barr Pharmaceuticals, Inc. (NYSE: BRL).

IMS Health (NYSE: RX) reported that "the value of the global pharmaceutical market is expected to grow 2.5 - 3.5 percent on a constant-dollar basis" in 2009.  IMS cut the forecast by a couple of percentage points because of current economic conditions.

Generic drug makers are poised to take advantage of the large number of branded pharmaceutical products that have, or will soon, lose their patent protection.  In addition, Reuters reports that manufacturing problems at some smaller generic drug companies might work to the advantage of the larger firms, such as Watson, by reducing competition.  The FDA is reported to have stepped up its scrutiny of drug makers. 

Watson had its own, minor misstep.  The company voluntarily recalled "one lot of Propafenone HCL 225 mg Tablets sold in 100 count bottles ... because some tablets may contain slightly higher levels of the active ingredient than specified."

More positively for Watson, a U.S. District Court ruled on 31 March 2009 that the generic version of Concerta® marketed by Watson Pharmaceuticals did not infringe on a patent held by ALZA and McNeil-PPC [both firms are owned by Johnson & Johnson (NYSE: JNJ)] because the patent was invalid.  Concerta® (methylphenidate hydrochloride extended-release tablets) is approved for the treatment of attention deficit hyperactivity disorder (ADHD).

Watson announced on 7 April 2009 the availability by prescription for RAPAFLO® (silodosin).  This new product is part of the company's growing urology franchise.  Watson received FDA approval for RAPAFLO in October 2008.  According to BioMedReports, Watson has also sought FDA approval to sell a generic version of the Enablex (darifenacin) bladder-control drug.  Developer Novartis (NYSE: NVS) has objected.

Looking back to the fourth quarter of 2008, we are reminded that Revenue grew by only 2.9 percent, but much lower Depreciation charges pushed Operating Income up 36.8 percent.  The contrarian Value Gauge rose to 18 of the 25 possible points in response to Watson's strong operating performance and lower price per share. The Overall Gauge increased from 47 to 56 of the 100 possible points.

Now, with the available data for the March quarter, our gauges display the following scores:
  • Overall: 42 of 100 (down from 56)

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 6.5 percent more than in the comparable period of 2008.  Our Revenue target, which was based on the company's guidance for all of 2009, proved to be too low by 2.5 percent.

The proportion of Revenue contributed by the Generic business segment increased from 58.5 percent in the first quarter of 2008 to 60 percent in the first quarter of 2009.  Watson attributed the increase in Generic revenues to new product launches and new products acquired.

The Cost of Goods Sold was 58.2 percent of Revenue, which translates into a Gross Margin of 41.8 percent in the first quarter of 2009.  The Gross Margin was a bit more profitable than the 41 percent we expected.  Watson improved on the 39.4 percent Gross Margin in the March 2008 quarter, even though generic drugs now make up a larger percentage of the sales mix.  This is because the newly launched and newly acquired generic drug products had a net higher margin than products sold in the earlier period.

The charge for Depreciation and Amortization in the quarter was 25 percent of the expected, per company guidance, $88 million charge for the year.   Acquired product rights constitute the bulk of Watson's amortizable assets.

The company spent 6.3 percent of Revenue on Research and Development.  The reported figure is slightly below what one would expect given the company's earlier forecast of 2009 R&D expenses between $180 million and $190 million.

Sales, General, and Administrative costs were 20.2 percent of Revenue, compared to our estimate of 17.7 percent.  The reported figure is much too high given the company's earlier forecast of 2009 SG&A expenses between $420 million and $430 million.  Excess SG&A expenses in the first quarter were due to an $18 million charge "related to a legal settlement with Elan Corporation, PLC (NYSE: ELN) related to naproxen sodium."

Operating Income, as we define it, was down 2.5 percent from the amount in the March 2008 quarter.  It fell short of our prediction by 5.9 percent.  However, if the legal charge mentioned above were excluded, Operating Income would have exceeded our forecast by 15.  The improved performance was primarily the result of better-than-expected Revenue.

Non-Operating items were slightly better than we expected because of a $1.5 million gain on the sale of assets in India.  Watson classifies this gain as an operating item, but it is the GCFR convention to do otherwise.

The Income Tax Rate rose from 38.1 percent to 38.6 percent.  Our target was much too low at 35 percent.  Watson reports that the higher rate "primarily reflects the impact of a California state legislative change in the current quarter which was partially offset by a reduction in the effective tax rate for the R&D tax credit and certain permanent differences."

Net Income was 3.0 percent less than the result of the year-earlier quarter, and it was 9.3 percent less than our prediction.  However, if the legal settlement were excluded, Net Income would have surpassed our estimate by a healthy amount.

Note that our calculation of Earnings per Share is slightly less ($0.01 to $0.02) than reported by Watson because we don't add interest expense on Contingently Convertible Debt, net of tax, to the income numerator.

Now for the gauges:

Cash ManagementMarch 2009
3 months prior12 months prior
Current Ratio1.4
2.1 years
2.1 years
2.0 years
120 days
117 days
127 days
Finished Goods/Inventory
Days of Sales Outstanding (DSO)44.4 days
41.2 days
48.3 days
Working Capital/Invested Capital 17.1%
Cash Conversion Cycle Time70.4 days
62.4 days
76.3 days
Gauge Score (0 to 25)

Watson reclassified about $575 million in contingent convertible debt from Long-term Debt to short-term debt.  Although the total debt load remained about the same, the reclassification greatly increased Current Liabilities, which depressed the Current Ratio, and it also decreased Working Capital.  The reclassification was necessary, according to the 10-Q, because Watson expect that debt holders will exercise an option in March 2010 that will require Watson to repurchase this debt for cash.

Watson will presumably attempt to refinance this debt at favorable terms over the next year.  The 10-Q did not identify refinancing as a risk.

To compute the percentage of Finished Goods in the Inventory we allocated 15 percent of the newly reported Inventory Reserves to Raw Materials, 15 percent to Work in-Process, and 70 percent to Finished Goods.  The lower ratio of Finished Goods provided some lift to the Cash Management gauge score because, in general, a drop in this ratio can signify that sales were better than the company expected (i.e., product was flying off the shelves).  In this case, some of the drop was the result of hiking Inventory Reserves for $35 million to $45 million.

GrowthMarch 20093 months prior12 months prior
Revenue growth5.1%
Revenue/Assets 71.6%
CFO growth
Net Income growth 48.0%
Gauge Score (0 to 25)10
Growth rates are trailing four quarters compared to four previous quarters.

Revenue and Revenue/Assets picked up in the latest quarter.  Net Income, helped by one-time factors, shows a potent growth rate.  Cash Flow from Operations, however, still appears tepid.

ProfitabilityMarch 20093 months prior12 months prior
Operating Expenses/Revenue 86.2%
ROIC 9.6%
Free Cash Flow/Invested Capital14.2%
Accrual Ratio
Gauge Score (0 to 25)11

Operating expenses as a percentage of Revenue has dropped substantially over the last year.  It's worth noting that Operating expense in the March 2009 quarter included $9.3 million (1.4 percent of Revenue) in restructuring charges associated with the company's Global Supply Chain Initiative.  Watson expects to recognize another $20 million to $30 million of these restructuring charges through 2010.

ROIC is mediocre, but better than one year ago.  The rise in the Accrual Ratio, relative to its value 12-months ago, suggests that Earnings Quality has degraded.  To be specific, 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.

ValueMarch 20093 months prior
12 months prior
P/E 15.5
P/E vs. S&P 500 P/E 88%
Price/Revenue 1.4
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)10

Shares of Watson Pharmaceuticals rose in price during the first quarter, from $26.57 to $31.11.  This 17-percent rise wasn't favorably received by the contrarian Value gauge, which is calculated using the quarter-end price.

Nevertheless, the current figures for the valuation ratios, which can be compared with other companies in the Generic Drug industry, suggest that Watson's share will remain appealing to Value Investors.

OverallMarch 20093 months prior
12 months prior
Gauge Score (0 to 100)41

Revenue in the first quarter rose at a healthier rate than we expected, and would have produced a nice gain in Net Income.  However, a charge associated with a legal settlement kept earnings growth in check.

The improvement in Gross Margin was encouraging, and it would have been greater if not for restructuring charges.

Tepid growth in Cash Flow from Operations is a concern.

The Cash Management, Growth, and Profitability gauges each dropped by 1 point in the first quarter.  The larger drop in the double-weighted Value gauge had a significant negative effect on the Overall gauge.

Watson has about one year to refinance about $575 million in contingent convertible debt because debt holders are expected to exercise an option in March 2010 that will require Watson to repurchase this debt for cash. 

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