10 May 2010

WPI: Income Statement Analysis for the March 2010 Quarter

Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.57 per share in the first quarter of 2010, which ended 31 March.  Watson made 36 percent more than the $0.42 it earned per share in the same quarter of 2009.

Adjusted, non-GAAP earnings increased from $0.69 to $0.81 per share in the latest quarter.  The adjustments exclude non-cash items, such as amortization and asset impairments.

This was the first full quarter after Watson's acquisition of Arrow, which closed on 2 December 2009.  The deal added about 20 generic drugs to Watson's growing product line.

This post examines Watson's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported Net Income was just slightly greater than our estimate, but a larger-than-expected number of shares outstanding threw our earnings-per-share estimate off by $0.05.

The principal sources for this income statement analysis were the earnings announcement, the ensuing conference call (transcript available from Seeking Alpha), and the formal 10-Q report.

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 $856.5 million surpassed the $667.4 million in the year-earlier quarter by $189 million, or 28 percent.   The Arrow Group acquisition is responsible for part of the Revenue increase, probably a large part.  As a rough indication, we note that Arrow's average Revenue was approximately $130 million per quarter during the first nine months of 2009

Our $823 million Revenue estimate, which assumed 23.5 percent of the projected annual Revenue would occur in the first quarter, was 4 percent too low.

The company's Global Generic business segment lifted its Net Revenue by $142 million (35 percent).  Watson credited the increase to additional international sales (probably due to Arrow) and to new products, such as metoprolol succinate extended-release tablets.

Global Brand segment Revenue fell $21 million, or minus 18.5 percent.  The decrease resulted from the termination last December of a supply and distribution agreement with Sanofi-Aventis involving Ferrlecit, used to treat iron deficiency anemia in some patients.  The Ferrlecit termination reduced Watson's Revenue by $36 million.  New products made up some of the loss.

Revenue from the Distribution segment increased a robust 44 percent.  This segment sells products other than those made by Watson itself.   The company stated that the Revenue increase "was primarily due to sales of generic versions of Aldara® and Flomax® launched in the first quarter 2010, as well as sales of new products launched late in 2009."

The Cost of Goods Sold increased to $505 million (58.9 percent of Revenue) from $389 million in 2009's first quarter.  The latest amount translates into a Gross Margin of 41.1 percent, which is 70 basis points less profitable than last year. 

The Gross Margin was a huge 390 basis points below the 45.0 percent we had estimated.  Where did we go wrong?  It wasn't the Generic segment, which achieved good sales and a 47.1-percent Gross Margin, consistent with expectations.  Branded pharmaceuticals achieved a healthy 73-percent Gross Margin, but these products were a smaller proportion of the overall sales mix than we anticipated.  Perversely, the Distribution segment's better-than-expected performance also hurt the Gross Margin.  The Distribution segment's margin was only 13 percent in the last quarter.

The charge for Depreciation and Amortization increased from $22 million to $39, but this result was expected and consistent with our estimate.  The higher charge resulted from the amortization of product rights acquired with Arrow.

Research and Development expenses increased 40 percent, from $42.3 million to $59.5 million.  As a percentage of Revenue, the R&D rose from 6.3 percent to 6.9 percent.  The reported amount nearly matched our expectations.

Sales, General, and Administrative costs rose from $135 million to $152 million, but this figure was also very close to the value we estimated.  SG&A fell from 20.2 percent of Revenue to 17.7 percent.

Subtracting the various operating expenses from Revenue yields Operating Income of $101 million, up 27 percent from $80 million in the year-earlier quarter.  The increase was mostly due to higher Revenue.  (For consistency with our standard presentation format, we moved the loss on asset sales from the operating to the non-operating expense category.)

Despite the big increase relative to last year, Operating Income in the latest quarter fell 15 percent short of our $119 million target.  The Gross Margin, as mentioned above, was significantly lower than we expected because of the sales mix.

The various non-operating items added up to income of $6.2 million.  This was a nice surprise because non-operating items normally sum to a net expense, not income.  The increase can be credited to a $23.4 million gain realized when Watson sold its equity interests in Scinopharm Taiwan Ltd.

The Income Tax Rate was 34.5 percent, down from 38.6 percent last year.  The rate fell because of non-recurring tax benefit related to the sale of a foreign subsidiary.   We expected the Income Tax Rate to be 39 percent. 

Bottom-line GAAP Net Income of $69.8 million ($0.57 per share) was 42 percent more than $49.1 million ($0.44 per share) in the year-earlier quarter.  Since our Net Income estimate was $69 million, we nearly stumbled onto the correct figure.  However, the 123 million diluted shares outstanding was 11 percent more than we had figured.  The additional shares resulted in the reported EPS falling $0.05 below our $0.62 estimate.

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

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