24 May 2010

WPI: Financial Gauge Analysis for the March 2010 Quarter

Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.57 per share on a GAAP basis in 2010's first quarter, which ended 31 March.  Reported earnings were 36 percent more than the $0.42 per share Watson made in the same quarter of 2009.

Adjusted earnings, which exclude certain non-cash items, increased from $0.69 to $0.81 per share.

In our earlier review of Watson's Income Statement, we compared the actual results to our "look-ahead" estimates.

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.  This post reports on the metrics for Watson Pharmaceuticals and the associated financial gauge scores.  The metrics were calculated using data from Watson's current and historical financial statements, including the latest 10-Q report.

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.

Watson completed its acquisition of Arrow Group on 2 December 2009 for about $1.75 billion in cash and stock. 

After a big corporate deal, it is important to keep in mind that a company's financial metrics can change considerably.  A transaction can lead to immediate accounting gains/losses plus restructuring and refinancing activities that span several quarters or longer.  Assets acquired might be quickly divested, either to raise cash or because they don't fit into the new organization.  Customers relationships might be affected. 

For these and other reasons, extra caution has to be taken when evaluating a company after a deal.  Comparing current data with historical results, which is a key part of the GCFR process, might produce misleading results.  It is often a good idea to "let the dust settle" before drawing any conclusions.

With this important caveat, Watson's latest quarterly results produced the following changes to the gauge scores:

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 Management31 Mar 201031 Dec 200931 Mar 20095-Yr Avg
Current Ratio2.
Debt/CFO (years)
Inventory/CGS (days)122.9121.0118.0118.5
Finished Goods/Inventory69.4%65.5%62.4%60.4%
Days of Sales Outstanding (days)52.650.043.751.1
Working Capital/Revenue26.6%29.1%30.1%42.1%
Cash Conversion Cycle Time (days)83.982.368.380.7
Gauge Score (0 to 25)651312

In part due to the Arrow acquisition, Long-term Debt increased to nearly $1.2 billion, a record dollar amount.  Watson issued $450 million in five-year notes and $400 million in 10-year notes.  However, at 37 percent of Shareholders' Equity, the Long-term Debt level is near the middle of its range.

Watson realized $94 million in March 2010, for an investment gain of $23.4 million, by selling its equity interests in Scinopharm Taiwan Ltd..

During the March 2010 quarter, Watson made a $200 million payment to reduce the balance due on a senior credit facility from $400 million to $200 million.  This credit facility was established in 2006 and is due to expire in 2011.

Liquidity is ample, with Working Capital equal to $890 million and Current Assets a desirable two times Current Liabilities.

Inventory, Days of Sales Outstanding, and the Cash Conversion Cycle Time all edged up, which could be signalling diminished cash efficiency.  However, it's also possible that the Arrow acquisition has temporarily skewed the numbers. 

Growth31 Mar 201031 Dec 200931 Mar 20095-Yr Avg
Revenue growth15.8%10.2%5.1%17.1%
Operating Profit growth42.2%46.4%34.6%28.4%
CFO growth0.0%-9.5%3.4%16.7%
Net Income growth2.5%-6.9%48.0%19.2%
Gauge Score (0 to 25)651110
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.

In the March 2010 quarter, the Arrow acquisition and new products helped Watson achieve Revenue growth of 28 percent.  We would not assume this growth rate will be sustained.

Trailing-year Cash Flow and Net Income growth rates are tepid.  To some extent, this has been due to one-time charges (acquisition and restructuring costs) and non-operating expenses (interest plus debt refinancing charges).

Profitability31 Mar 201031 Dec 200931 Mar 20095-Yr Avg
Operating Expenses/Revenue86.3%86.2%86.2%88.1%
Free Cash Flow/Invested Capital11.2%9.5%14.3%13.5%
Accrual Ratio13.1%14.7%-2.4%2.1%
Gauge Score (0 to 25)44119

The Operating margin was stable over the last year.

The small improvements over the last year in ROIC and its Free Cash Flow equivalent are encouraging, but the rates of return are not robust enough to have a meaningful impact on the gauge scores.  They should rise if special charges aren't repeated.

A one-year rise in the Accrual Ratio can be a warning of Earnings Quality degradation.  In this case, the $1 billion in Cash Used for Investments in the fourth quarter of 2009 has distorted the figures.

Value31 Mar 201031 Dec 200931 Mar 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)14.815.09.510.6
Gauge Score (0 to 25)12109
Share Price ($)$41.77$39.61$31.11-

Watson's share price rose 34 percent in the year ending 31 March.  It has even resisted the recent widespread market downturn, as the shares remain close to $43.

Since earnings and sales didn't grow at that torrid pace, the price-oriented multiples all rose and kept the Value gauge near the bottom of its range.

Overall31 Mar 201031 Dec 200931 Mar 20095-Yr Avg
Gauge Score (0 to 100)14144438

Watson now has one quarter under its belt after the Arrow acquisition.  Although there were encouraging data in the first quarter 2010 results, earlier special items and the surge in the company's shares kept the gauge scores low.  The gauges, which are backward looking, need to see sustained earnings and cash flow growth.

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

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