24 February 2010

WPI: Income Statement Analysis for the December 2009 Quarter

Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.51 per share in the fourth quarter of 2009, which ended 31 December, up from $0.50 in the same quarter of 2008. 

The latest quarter was unusual in that it included about one month of Arrow Group results.  Watson's acquisition of Arrow, which closed on 2 December 2009, added about 20 generic drugs to Watson's growing product line.

Adjusted, non-GAAP earnings increased from $0.64 to $0.85 per share in the fourth quarter.

This post examines Watson's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Our estimate did not include any Arrow Group results, and it is difficult to determine what Watson might have earned had the acquisition not been made.

The principal sources for the income statement analysis were the earnings announcement and the ensuing conference call (transcript available from Seeking Alpha).

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.  Additional 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.

Revenue of $786 million surpassed the amount in the year-earlier quarter by 21.8 percent.

We're not sure how much of the Revenue increase to attribute to the Arrow acquisition in December.  However, we can make a rough estimate.  Watson previously disclosed that Arrow's Net Revenue during the first three quarters of 2009 was $391.4 million, for an average of $43.5 million per month.  Using this average to approximate Arrow's December results, Watson's non-Arrow Revenue in the fourth quarter could have been, roughly, $785.7 million minus $43.5 million = $742.2 million.

This estimated amount is 15 percent more than Watson's Revenue in the December 2008 quarter, and it is 4.5 percent more than our $710 million (non-Arrow) target for Watson's fourth-quarter 2009 Revenue.

For the year, Revenue of $2.79 billion beat Watson's $2.7 billion guidance.

Sales by the company's Global Generic business segment, which now includes Arrow, increased $95 million (26 percent).  Watson attributed this rise to both new products and products acquired from Arrow.

Global Brand segment Revenue rose a less robust 5 percent.  Lower sales of some branded products were offset by newer products and higher revenues from co-promoted products.

Revenue at the Distribution segment increased a healthy 22 percent.  This segment sells products other than those made by Watson itself.

The Cost of Goods Sold was 58.7 percent of Revenue, which translates into a Gross Margin of 41.3 percent.  The margin contracted from 41.7 percent in the year-earlier quarter, and it was down from 46.6 percent in September 2009.  We had assumed the Gross Margin would be 45 percent.

Not surprisingly, branded pharmaceuticals achieved the most lucrative Gross Margin at 81.5 percent.  Generics had a Gross Margin of 46.7 percent (up from 43.3 percent) as result of cost-saving initiatives.  The Distribution segment's margin slipped from 15.6 percent to 14.6 percent because of a change in the product mix.

The charge for Depreciation and Amortization increased from $20.1 million to $26.5 million.  The latest amount includes $4.3 million related to the Arrow acquisition, possibly amortization of acquired intangible assets.  Excluding the acquisition charge, this expense was about the same as the $22 million we expected.

Research and Development expenses increased 27 percent, from $47.6 million to $60.5 million.  Arrow's R&D boosted the latest figure by as much as $7.6 million (our guess is $6 million).  We had expected R&D in the fourth quarter to equal $48 million, so this expense excluding Arrow was at least a few million more than our target.  Watson stated that is "aggressively fil[ing] new product applications."

Sales, General, and Administrative costs rose from $111 million to $137 million, much more than our $115 million estimate.  Management stated that

Roughly, half of this increase is due to the inclusion of Arrow in our fourth quarter results. The remainder is primarily due to higher litigation cost and higher promotional spending in our Brand division.

The various operating items combined to produce Operating Income of $100 million, an 11.2 percent gain over the $90 million in the year-earlier quarter.  The improvement was mostly due to top-line Revenue growth offset by substantially higher costs.  Some of the additional costs were one-time expenses.

Although Revenue was greater than we expected, the higher-than-anticipated costs resulted in Operating Income well below our $135 million estimate.

The non-operating interest expense was more than twice as high as in the December 2008 quarter because Watson has more debt outstanding.  However, non-operating items in the aggregate almost matched our estimate.

Our target for the Income Tax Rate was 36 percent, and the actual rate was 36.6 percent. 

Bottom-line GAAP Net Income of $56.9 million ($0.51 per share) was slightly more than $56.4 million ($0.50 per share) in the year-earlier quarter.  Not including any Arrow Group results in our estimates, we were looking for Net Income of $80 million ($0.70/share).  The earnings report doesn't break out the data in way that would allow us to characterize the difference fully.

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

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