07 November 2009

WPI: Income Statement Analysis for the September 2009 Quarter

Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.54 per share in the third quarter of 2009, down from $0.60 in the same quarter of last year.  [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).]

This post examines the Income Statement for the quarter in the earnings announcement and the more detailed 10-Q and compares the entries on each line to our "look-ahead" estimates.  Our target for Watson's Net Income in the latest quarter was $0.56 per share.

In a second article, we will report Watson's scores as measured by the GCFR financial gauges. The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

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.

Please click here to see a full-sized, normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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.

Watson's Revenue was 3.3 percent more than in the year-earlier quarter.  Our estimate proved to be 3.5 percent too high.

Revenue was $2.01 billion during the first nine months of 2009.  To reach the company's $2.7 billion guidance for the year, another $700 million will be needed in the fourth quarter.  Revenue has been close to $670 million in each of the first three quarters, so $700 million would be a modest improvement.

New products are already having a positive effect on Revenue.  Thanks to recently launched generic drugs, the Generic business segment brought in 9.4 percent more Revenue in the September 2009 quarter than the September 2008 quarter.  Brand segment Revenue rose a less robust, but healthy, 6.3 percent.

The weak area was the Distribution segment, where Revenue fell 11.4 percent.  This segment distributes products other than those made by Watson itself.

The Cost of Goods Sold was 53.4 percent of Revenue, which translates into a Gross Margin of 46.6 percent.  This is the highest quarterly Gross Margin achieved by Watson since 2005, and it was significantly more profitable than last year's 39.7 percent.

Watson handily surpassed our estimate of 42 percent for the Gross Margin.

The Gross Margin for generic drugs soared from 41.6 percent to 48.7 percent. The company credited its Global Supply Chain Initiative for lowering costs.  The Gross Margin for Branded pharmaceuticals did even better, surging from 71.5 percent to 81.6 percent.  At the Distribution segment, the Gross Margin slipped from 15.7 percent to 14.9 percent.

The charge for Depreciation and Amortization in the quarter matched our $22 million target.  Now 75 percent through the year, management's guidance to expect an $88 million Amortization expense in 2009 appears to have been accurate.

Research and Development expenses were $8 million more than our $44 million target.  Biostudy costs increased for generic drugs, and clinical spending rose for branded pharmaceuticals.  With the higher third-quarter amount, the reported figures for the first nine months of 2009 have become consistent with the company's forecast that R&D expenses would be between $180 million and $190 million in 2009.

Sales, General, and Administrative costs were $5 million more than the $115 million value we estimated.  Watson reported that they incurred additional costs when launching the RAPAFLO® (silodosin) and Gelnique (oxybutynin chloride) products.

Operating Income, which we define as the difference between Revenue and the operating expenses identified above, was 30.9 percent greater than the amount attained in last year's September quarter.  Our prediction for Operating Income was 6.5 percent too low.  The better-than-expected Gross Margin more than compensated for the weaker-than-expected Revenue and some higher-than-expected expenses.

Non-Operating items were more substantial than normal, and their net effect was to bring pretax income under our estimated value -- erasing the better-than-expected operating results. Non-operating results were hurt by a loss on the early extinguishment of debt, greater interest expenses, and much lower "other income."

Our target for the Income Tax Rate was 37 percent, and the actual rate was 38.4 percent.  The rate was lifted by non-deductible acquisition costs and foreign asset impairment.

Net Income was 11.3 percent less than the result of the year-earlier quarter, and it was 6 percent less than our prediction.  The shortfall was, to a large extent, the result of the higher non-operating expenses.

In summary, Revenue in the third quarter did not rise as much as we expected, but a much lower Cost of Goods Sold (and, thus, higher Gross Margin) led to stellar Operating results.  The story concerning Non-operating items, such as debt expenses, was much less favorable and hurt the bottom line.

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

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