29 December 2009

WPI: Look Ahead to December 2009 Quarterly Results

Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $63.0 million in the third quarter of 2009, down from $71.1 million in the same quarter of last year.  Good operating results were masked by lower non-operating income and higher non-operating expenses. 

In November, we examined Watson's Income Statement for the September quarter and compared the entries on each line to our "look-ahead" estimates.  We later performed a financial gauge analysis of Watson, which determined that the GCFR Overall gauge fell from 38 to 29 of the 100 possible points.

We have now modeled Watson's Pharmaceuticals' Income Statement for the quarter that will end on 31 December 2009.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data the company will announce in February 2010.  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. 

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

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.

On 2 December 2009, Watson completed the acquisition of international generic drug maker Arrow Group for $1.05 billion in cash, 16.9 million Watson shares (worth over $600 million), and $200 million in other securities.   Watson and Arrow agreed to the divestitures spelled out in a consent order with the U.S. Federal Trade Commission to resolve antitrust concerns and get the regulatory approvals required to consummate the deal.

Some of the cash Watson used for the Arrow transaction may have come from the sale, last August, of $450 million 5.000% Senior Notes due 2014 and $400 million 6.125% Senior Notes due 2019.  Watson also borrowed $275 million under the terms of a revolving credit facility.  Leveraged Finance News reported 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.

The Arrow acquisition will expand Watson's non-U.S. operations and help it compete with 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 Teva had to divested after it acquired Barr Pharmaceuticals.

This month, Piper Jaffray initiated coverage on Watson Pharmaceuticals with an Underweight rating.

We're now ready to look specifically at the current quarter.

Watson adjusted its outlook for the year when it announced third quarter results:

2009 Financial Outlook

Based on actual results for the first nine months of 2009 and the forecast for the remainder of the year, Watson is adjusting its estimates for the full year 2009. GAAP earnings per diluted share is estimated to be between $2.04 and $2.12, and as detailed in reconciliation Table 6, Watson has affirmed its estimate for adjusted earnings per diluted share, which is expected to be between $2.50 and $2.58. Excluding special items as detailed in the EBITDA reconciliation Table 7 below, adjusted EBITDA continues to be between $668 million 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 $1.60 billion and $1.65 billion.
— Total Brand segment revenue between $450 million and $465 million.
— Total Distribution segment revenue between $620 million and $640 million.

Watson's estimates are based on the Company’s actual results for the first nine 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 fourth quarter of 2009.

[emphasis added]

Because the Arrow acquisition was consummated on 2 December, Arrow's results for the last month will probably be consolidated with Watson's results for the fourth quarter.  We cannot make any estimates for the Arrow contribution because we have not seen Arrow's financial statements. 

By summing the midpoint of Watson's full-year Revenue guidance for each business segment, and subtracting the actual Revenue during the first three quarters, we are left with $705.5 million for the fourth quarter.  We are rounding this up to $710 million, which would be 10 percent more than Revenue in the December 2008 quarter.

The Gross Margin was between 40 and 42 percent of Revenue in most quarters of the last few years, but the margin surged to 46.6 percent in the September 2009 quarter.  During the most recent conference call, CEO Paul Bisaro described the margin improvement as "sustainable" and due to "operating efficiencies delivered by our global supply chain initiative as well as the contribution of new products."

For the fourth quarter, we are being a little more conservative and assuming the Gross Margin will be 45 percent.  Therefore, our estimate for the Cost of Goods Sold is (1 - 0.45) * $710 million, which equals $391 million.

In Watson's initial guidance for 2009, management stated that 2009's Amortization expense would be about $88 million.  The first three quarters were entirely consistent with this target, and we will assume another $22 million for the fourth quarter.

The company also forecast that annual Research and Development expenses would between $180 million and $190 million.  Our estimate for R&D in the fourth quarter is $48 million, which would bring the annual amount to $185 million.

Watson had originally predicted this year's Sales, General, and Administrative expenses would be between $450 and $470 million, but special charges were higher than anticipated.  The company's latest estimate for the year is $500 million, which means the fourth-quarter amount will be closer to $115 million.

These estimates would result in Operating Income of $135 million, nearly 50 percent more than in last year's fourth quarter.

Given the additional debt incurred, we expect to see higher interest expenses.  We are assuming a net non-operating expense of $10 million, which might be a little high.

With a 36 percent Income Tax Rate, Net Income for the quarter would be $80 million ($0.70/share).  For the year, Net Income would be $245 million ($2.08 per share).

We have not included any Arrow Group results in our estimates.

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.

Note: Yahoo Finance was the source of the historical share price data in the chart above.

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

No comments:

Post a Comment