24 November 2009

WPI: Financial Gauge Analysis for the September 2009 Quarter

In a previous article, we examined Watson Pharmaceuticals' (NYSE: WPI) Income Statement for the third quarter of 2009 and compared the entries on each line to our "look-ahead" estimates.  Earnings in this period, which ended 30 September 2009, fell from $0.60 to $0.54 per share.  [Note: our per-share numbers are slightly different than the official results because we don't adjust for interest expenses on convertible contingent senior debentures (CODES).]

Using the financial statements in the earnings announcement and the more detailed 10-Q , we have now updated our usual set of Cash Management, Growth, Profitability and Value metrics.  This post reports on the metrics and the associated financial gauge scores.

Watson Pharmaceuticals develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products.  Some background information about Watson and the business environment in which it is currently operating can be found in the look-ahead.

In summary, Watson's latest quarterly results produced the following changes to the gauge scores:
  • Overall: 29 of 100 (down from 38)
The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary.  Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.

Cash ManagementSep 2009Jun 2009Sep 20085-Yr Avg
Current Ratio4.
Debt/CFO (years)
Inventory/CGS (days)119.2117.0122.4122.5
Finished Goods/Inventory (1)
Days of Sales Outstanding (days)47.645.342.851.0
Working Capital/Invested Capital58.2%20.3%36.6%40.0%
Cash Conversion Cycle Time (days)77.367.274.384.2
Gauge Score (0 to 25)1012813
1. To make current inventory data more comparable with historical figures, we decrement the reported value of the finished goods inventory by 70 percent of the inventory reserve charge.

In August 2009, Watson refinanced much of its debt  -- an action for which we had been waiting -- when the company issued $450 million in five-year notes and $400 million in 10-year notes.

The refinancing improved liquidity by erasing nearly all of the $726 million in Short-term Debt that had been on Watson's Balance Sheet in June, but Long-term Debt increased from $150 million to $997 million.  Total debt, therefore, rose about $123 million.  Management might be putting some money aside to repay the $150 million due in November 2011 under a credit facility put in place in 2006.

The combination of cash from the debt offering and the redemption of the debt that had been due within one year caused the Current Ratio and net Working Capital to bounce back from temporarily depressed levels to above-normal figures.

Inventory had been slowly decreasing in an encouraging trend.  However, the trend ended in the September quarter.  The small increase does not presently worry us because the finished goods inventory category continued to fall.

GrowthSep 2009Jun 2009Sep 20085-Yr Avg
Revenue growth5.4%6.5%1.1%14.0%
Operating Profit growth41.5%37.9%23.7%21.9%
CFO growth0.1%4.4%5.7%12.5%
Net Income growth0.5%24.8%N/A10.4%
Gauge Score (0 to 25)31159
Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters.
The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.

Revenue growth is not torrid, but new generic and branded pharmaceutical products are starting to contribute to sales. 

Bottom-line gains, whether measured by Cash Flow or Net Income, are tepid when the last four quarters are compared to the four previous quarters.  To some extent, this has been due to one-time charges (such as acquisition costs) and non-operating expenses (such as debt refinancing).

ProfitabilitySep 2009Jun 2009Sep 20085-Yr Avg
Operating Expenses/Revenue85.8%86.7%86.7%87.5%
Free Cash Flow/Invested Capital13.9%14.1%13.3%14.7%
Accrual Ratio-1.9%-2.1%-3.7%0.0%
Gauge Score (0 to 25)1010139

Operating expenses as a percentage of Revenue were reduced 90 basis points over the last year.  This is impressive given that lower-margin generic drugs are responsible for a growing proportion of overall sales.  

The numbers may be distorted to some extent by the business restructuring effort, which Watson calls the "Global Supply Chain Initiative."  Aiming to reduce costs in the long run, Watson will incur pretax restructuring charges totaling $60 million and $70 million in fiscal years 2008 to 2010.

The small improvement over the last year in ROIC and its Free Cash Flow equivalent is encouraging in the current economic climate.  It's possible that restructuring and refinancing activities interfering with comparisons between current and historical returns on investment.

The rise in the Accrual Ratio, relative to its value 12 months ago, suggests some degradation to Earnings Quality.  To be specific, it indicates that less of the company's Net Income is due to Cash Flow from Operations; therefore, more is due to changes in non-operational Balance Sheet accruals.

ValueSep 2009Jun 2009Sep 20085-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)10.810.39.310.1
Gauge Score (0 to 25)58159

In the year ending 30 September 2009, Watson shares increased in price 28.6 percent, from $28.50 to $36.64.   Since the company's operating results rose much more modestly, the contrarian Value gauge is reacting negatively.

OverallSep 2009Jun 2009Sep 20085-Yr Avg
Gauge Score (0 to 100)29384740

We had thought the gauge scores would improve after a successful debt refinancing, but declines in the Growth and Value scores predominated in the third quarter. 

These results need to be taken with an extra dose of skepticism.  Our ability to assess Watson using historical results has been made much more difficult by the company's concurrent acquisition of Arrow Group, business restructuring, and the issuance of $850 million in new debt.  It may take a few quarters for the view ahead to clear.

Note: We thank Yahoo! Finance for making the share price chart available.

Full disclosure: No position in WPI at the time of writing.

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