31 December 2010

WPI: Look Ahead to December 2010 Quarterly Results

This post describes our model of Watson Pharmaceuticals' (NYSE: WPI) Income Statement for 2010's fourth quarter, which ends today.

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., produces and distributes generic and, to a lesser extent, branded pharmaceuticals.  Watson earned $222 million in 2009, down from $238 million in 2009.  Revenue increased from $2.5 billion to $2.8 billion.

The company's market value is currently about $6.4 billion on a fully diluted basis.

The Arrow Group acquisition in December 2009 augmented Watson's portfolio of generic drugs and expanded the company's access to international markets.  Arrow was not Watson's first large acquisition: it purchased Andrx in late 2006.  The company also obtained 15 drugs in 2008 from Teva Pharmaceutical (NASDAQ: TEVA).

As a result of these deals, Watson should now be better postured to compete against generic giants Teva and Mylan (NYSE: MYL). 

Watson's business is divided for financial reporting purposes into three segments: Global Generics, Global Brands and Distribution.  With 170 different products, Global Generics contributed 59.7 percent of Revenue in 2009 and 71.6 percent of allocable operating income. 

Global Brands had 30 pharmaceutical products in 2009, with several in Women's Health and Urology markets.  This business yielded 16.5 percent of Watson's Revenue and 23.1 percent of operating income in 2009.  In 2010, Global Brand revenue has benefited from sales of products launched in 2009, most notably RAPAFLO and Gelnique

New sales have helped offset revenue lost due to the termination last December of a supply and distribution agreement with Sanofi-Aventis (NYSE: SNY) involving Ferrlecit.  (Watson stated in their 2009 10-K that Ferrlecit was responsible for approximately 12 percent of the company's "gross profit" in 2009.)

Another new product about to emerge from the pipeline is a "novel" oral contraceptive that is chewable.  Approved by the FDA in December 2010, and licensed from Warner Chilcott (NASDAQ: WCRX), Watson's Global Brands unit will begin selling this product in the second quarter of 2011.

The Distribution segment generated 23.8 percent of Revenue and 5.2 percent of operating income in 2009.

Watson Pharmaceuticals earned $0.21 per diluted share on a GAAP basis in the September-ending third quarter of 2010, down approximately 60 percent from $0.54 in the same three months of last year.  The most recent quarter included a nearly $90 million charge related to a legal settlement involving drug pricing.  Excluding certain non-cash items in both periods, adjusted earnings per share rose 9 percent, from $0.78 to $0.85.

Readers wanting to take another look at Watson's September 2010 quarter might wish to review our Income Statement analysis.

We are now ready to look specifically at the December 2010 quarter.

When Watson in August announced its third-quarter results, it also updated its sales and earnings forecasts for fiscal 2010.

2010 Financial Outlook
Watson’s estimates are based on actual results for the third quarter 2010 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 31, 2010 at approximately $3.5 billion.
    • Total Global Generics segment revenue of approximately $2.3 billion
    • Total Distribution segment revenue of approximately $825 million
    • Total Global Brands segment revenue of approximately $400 million
  • Adjusted EBITDA between $835 million and $850 million
  • Cash earnings per share between $3.37 and $3.45
Additional guidance emerged during the ensuing conference call (transcript available from Seeking Alpha).

For the full year 2010, we now expect total R&D spending on a GAAP basis to be in the range of $265 million to $275 million.

For 2010, we expect our SG&A spending on a GAAP basis to be in the range of $700 million and $720 million.
(includes $90 million charge taken in the third quarter)

For 2010, we expect amortization expense to be approximately $180 million.

For 2010, we now expect the GAAP-effective tax rate to be approximately 30%. On an adjusted cash basis, we continue to expect our 2010 effective tax rate to be approximately 37%.

Revenue in the first nine months of 2010 was $2.61 billion.  Another $886 million in the fourth quarter would bring the full-year amount to the company's $3.5 billion guidance.  We have rounded the fourth-quarter Revenue target up to $900 million.

This estimate is 14.5 percent more than revenue in 2009's fourth quarter.  Since Watson's acquisition of Arrow closed on 2 December 2009, the earlier quarter included about one month of Arrow's business.

We expect Watson's Gross Margin in the December quarter to be 45 percent of Revenue, about what it was in the September quarter.  Combining our estimates for Revenue and Gross Margin produces a fourth-quarter target for the Cost of Goods Sold of (1 - 0.45) * $900 million = $495 million.

Watson expects its Amortization expense in 2010, which is excluded from the company's Cash EPS guidance, to be around $180 million.  A fourth-quarter expense of $50 million would achieve a full year result consistent with the guidance.

Annual Research and Development expenses are forecast to be between $265 million and $275 million.  The actual R&D expense in the first nine months of the year was $197 million, which suggests the expense should be about $73 million in the fourth quarter.

This year's Sales, General, and Administrative expense is projected to be between $700 and $720 million.  After making an adjustment for the third-quarter's settlement charge, which we handled separately, we arrive at a fourth-quarter SG&A estimate of $160 million.
These estimates would result in Operating Income of $122 million, some 22 percent more than last year's $100.2 million.

We are assuming a net non-operating expense of $17 million.

With a 35 percent predicted income tax rateNet Income for the fourth quarter would be $68.3 million ($0.55/share).  This compares to $56.9 million ($0.51 per share) in December 2009. 

Ignoring amortization to approximate (roughly) cash earnings, which is the type of earnings on which many analysts focus, our projection for the December 2010 quarter rises to $99.5 million ($0.80 per share).

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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