06 April 2010

WPI: Look Ahead to March 2010 Quarterly Results

This post describes our model of Watson Pharmaceuticals' (NYSE: WPI) Income Statement for the first quarter of 2010, which ended on 31 March.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing 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. 

The acquisition of Arrow Group, which closed on 2 December 2009, has expanded Watson's portfolio of generic drugs and expanded its international reach.  These enhancements should help Watson compete against generic giants Teva Pharmaceutical (NASDAQ: TEVA) and Mylan (NYSE: MYL). 

Arrow cost Watson nearly $2 billion with slightly more than half, $1.05 billion, paid in cash.  To get the regulatory approvals required to consummate the deal, various assets were divested in accordance with a consent order with the U.S. Federal Trade Commission

The Arrow deal follows Watson's acquisition of Andrx in late 2006 and the 2008 purchase of 15 drugs that Teva had to divest after it acquired Barr Pharmaceuticals.

Watson earned $222 million on Revenue of $2.8 billion in 2009.  The corresponding figures for 2008 were $238 million and $2.5 billion.

The company's current market capitalization is $5.2 billion.

The business is divided for reporting purposes into three segments: Global Generic, Global Brand and Distribution.  The Global Generic segment contributed 59.7 percent of Revenue in 2009 and 71.6 percent of allocable operating income.  The Global Brand segment contributed 16.5 percent of Revenue and 23.1 percent of allocable operating income.  The Distribution segment contributed 23.8 percent of Revenue and 5.2 percent of allocable operating income.

The New York Times reported in February 2010 that brand-name pharmaceutical companies have been selling more "branded generics" in emerging markets.

We're now ready to look specifically at the March 2010 quarter.

A starting point is Watson's own forecast for 2010, which it presented [pdf] on 21 January 2010 at an Investor Day in New York.

2010 Financial Outlook
Watson estimates total net revenue for 2010 will be approximately $3.5 billion.

— Total Generic segment revenue of approximately $2.3 billion.
— Total Brand segment revenue of approximately $460 million.
— Total Distribution segment revenue of approximately $700 million.

Cash earnings for 2010 is expected to be between $3.05 and $3.30 per diluted share and adjusted EBITDA is expected to be between $760 million and $810 million.

Additional detail was provided when Watson announced the results of the fourth quarter of 2009.

2010 Financial Outlook

Watson's estimates are based on actual results for 2009 and management's current belief about prescription trends, pricing levels, inventory levels and the anticipated timing of future product launches and events.

Watson estimates total net revenue for the full year ended December, 2010 at approximately $3.5 billion.
  • Total Global Generic segment revenue between $2.2 and $2.4 billion, with international revenue between $550 and $610 million
  • Total Global Brand segment revenue of approximately $440 and $480 million
  • Total Distribution segment revenue between $670 and $740 million
Selling, General and Administrative expenses between $630 and $680 million

Research and Development expenses between $240 and $260 million

Adjusted EBITDA between $760 million and $810 million

Cash earnings per share between $3.05 and $3.30.

Additional guidance emerged during the conference call

For the Income Statement model, we need to distribute the annual estimates of Revenues and expenses over the four quarters of the year.  Our assumption is that the figures will increase modestly and linearly from quarter to quarter. 

As a starting point, we have allocated 23.5 percent of the projected annual amounts to the first quarter.  If this ratio proves too high or too low once the actual results are issued, we will make the necessary adjustments for the second quarter.

For example, with Revenue for the 2010 expected to be $3.5 billion, our estimate for the first quarter is 0.235* $3.5 billion = $822.5 million.

Watson provided broad Gross Margin expectations for the Global Generic ("high 40s") and General Brand ("70 range") businesses.  When we mixed in a 15-percent margin for the the Distribution business, and weighted the margins by the expected segment Revenue, we came up with an overall Gross Margin estimate of 45 percent.  Therefore, our estimate for the Cost of Goods Sold in the March quarter is (1 - 0.45) * $822.5 million, which equals $452 million.

Management stated that 2010's Amortization expense would be about $170 million.  Our estimate for the first quarter is 0.235 * $170 million = $40 million.  Note that this expense is probably excluded from the company's Cash EPS guidance.

Watson also forecast that annual Research and Development expenses would between $240 million and $260 million.  Our estimate for R&D in the first quarter is 0.235 * $250 million = $59 million.

This year's Sales, General, and Administrative expense is projected to be between $630 and $680 million.  Our first quarter estimate is 0.235 * $650 million = $153 million.

These estimates would result in Operating Income of $119 million, some 43 percent more than in last year's first quarter.

Given the additional debt incurred with the acquisition, we expect to see modestly higher interest expenses.  We are assuming a net non-operating expense of $6 million.

With a 39 percent Income Tax Rate, Net Income for the quarter would be $69 million ($0.62/share).  If the amortization and interest expenses are excluded, the earnings estimate would be $0.20 higher

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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