22 September 2009

WPI: Look Ahead to September 2009 Quarterly Results

The GCFR Overall Gauge of Watson Pharmaceuticals, Inc. (NYSE: WPI) slipped from 43 to 39 of the 100 possible points in the second quarter of 2009.  Our income statement and financial gauge analyses explained in some detail how the score was attained.

New generic drugs helped Watson bring in 9 percent more Revenue than in the second quarter of last year.  The additional Revenue was offset, however, by product-launch costs and by expenses related to the planned acquisition of Arrow Group.  As a result, Net Income fell by 12 percent.

We have now modeled Watson's Income Statement for the third quarter of 2009, which will end on 30 September.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data that the company will announce in October.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we set the stage with some background information about Watson and the business environment in which it is currently operating.  Readers that keep close tabs on the company might want to skip ahead.

Watson Pharmaceuticals, Inc., develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products.

In June 2009, Watson reached an agreement to acquire international generic drug maker Arrow Group for $1.05 billion in cash, $500 million in Watson common stock, and $200 million in other securities.  A limited overview of Arrow can be found on the web site of Cobalt Pharmaceuticals, a subsidiary.

This acquisition will expand Watson's non-U.S. operations and help it compete with international firms such as Teva Pharmaceutical (NASDAQ: TEVA) and Mylan (NYSE: MYL).  The latest deal follows Watson's acquisition of Andrx in late 2006 and the purchase of 15 drugs that were divested, to resolve antitrust concerns, after Teva acquired Barr Pharmaceuticals.

In August, Watson issued $450 million 5.000% Senior Notes due 2014 and $400 million 6.125% Senior Notes due 2019.  The net proceeds:

are expected to be used to repay approximately $100.0 million of the Company’s term loan borrowings, to redeem the $575.0 million aggregate principal amount of the Company’s convertible contingent senior debentures due 2023, and to fund a portion of the cash consideration payable in the Company’s pending acquisition of Robin Hood Holdings Limited [holding company for Arrow Group] ...

Leveraged Finance News reports that the bonds were rated Ba1 by Moody’s and BBB- by Standard & Poor’s and Fitch Ratings.  These ratings are on the investment grade border.

Generic drug makers are taking advantage of the large number of branded pharmaceutical products that have, or will soon, lose their patent protection.  Some big makers of branded pharmaceuticals, in response to proposed health care reforms that favor lower-priced drugs, are also making bets on generic drugs.

Market research firm RNCOS claims in a published report available for purchase:

The US generics market is forecasted to grow at a CAGR
[Compound Annual Growth Rate] of around 9.2% during 2010-2012, says our recent research report “Booming US Generic Drug Market”.

IMS Health (NYSE: RX), when announcing its initial 2009 forecast of the global pharmaceuticals market, predicted that sales of generic drugs would grow five to seven percent.  IMS later reduced its overall forecast for pharmaceutical sales by about 2 percent, in recognition of the weak economy, but we did not see a specific update for generic sales.

The FDA recently approved Watson's application for levonorgestrel, which is the generic equivalent to Duramed Pharmaceuticals' PLAN B, for over-the-counter use by adult women.  Duramed became a unit of Teva after the latter purchased Barr.

We're now ready to look ahead.

Watson, when it announced second-quarter results, adjusted its guidance for the year.

Based on actual results for the first six months of 2009 and the forecast for the remainder of the year, Watson is adjusting its estimates for the full year 2009.  Watson has increased its estimates for GAAP earnings per diluted share to between $2.13 and $2.21, and [...] adjusted earnings per diluted share is now estimated to be between $2.50 and $2.58. Excluding special items [...], adjusted EBITDA is now estimated to be between $668 and $685 million.

Watson estimates total net revenue for the full year of 2009 at approximately $2.70 billion. Estimates for segment revenue are as follows:

— Total Generic segment revenue between $1.55 billion and $1.65 billion.
[up from $1.50B to $1.60B]
— Total Brand segment revenue between $445 million and $470 million.
— Total Distribution segment revenue between $630 million and $660 million.
[down from $660M to $710M]

Watson's estimates are based on the Company’s actual results for the first six months of 2009, and management's current belief about prescription trends, pricing levels, inventory levels and the anticipated timing of future product launches and events. Watson’s forecast for 2009 excludes the impact of the acquisition of Arrow Group, which is expected the close in the second half of 2009.

[emphasis added]

The quotation above would seem to indicate that Watson had just lifted its guidance for GAAP full-year EPS.  However, the company's guidance for this figure after the 2009's first quarter was:

Watson has increased its estimates for GAAP earnings per diluted share to between $2.15 and $2.27, and as detailed in reconciliation Table 6, adjusted earnings per diluted share is now estimated to be between $2.40 and $2.52.

It's hard to see how a change from ($2.15 to $2.27) to ($2.13 to $2.21) could be characterized as an increase.  Caveat emptor.

Since Revenue was a bit more than $1.3 billion in the first two quarters of 2009, Watson was evidently expecting a combined Revenue of almost $1.4 billion in the second half of the year.  We are assuming $685 million will be realized in the September quarter.  This figure is 6.3 percent more than Revenue in the September 2008 quarter.

The guidance didn't address Gross Margin.  We will assume that the margin will equal the 42 percent of Revenue achieved in the first two quarters of the year.  Therefore, our estimate for the Cost of Goods Sold in the third quarter is (1 - 0.42) * $685 million, which equals $397 million.

In its initial guidance for 2009, management stated that 2009's Amortization expense is expected to be $88 million.  The first half was on track with a $44 million expense, and we will assume another $22 million for the third quarter.

The company forecast Research and Development expenses for 2009 between $180 million and $190 million.  However, the year-to-date results suggest the annual total will be lower.  Our estimate for R&D in the third quarter is $44 million, which is a little more than in each of the first two quarters.

Watson also predicted this year's Sales, General, and Administrative expenses will be between $450 and $470 million.  Special charges have inflated the expense in each quarter beyond the expected $115 per quarter rate.  We will look for a more normal figure in the September quarter.

These estimates would result in Operating Income of $107 million.  This amount is 22 percent more than in last year's third quarter.

Watson's non-operating income and expenses are typically minor.  We assume they will cancel each other out.

With a 37 percent Income Tax Rate, Net Income will be $67 million ($0.56/share) for the quarter.  Net Income in 2008's third quarter was $71 million ($0.60/share).

Please click here to see a full-sized, normalized depiction of the projected results next to Watson's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: No position in WPI or any other firm mentioned in this post at the time of writing

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