18 February 2011

WPI: Income Statement Analysis for the December 2010 Quarter

Watson Pharmaceuticals (NYSE: WPI) earned $0.15 per diluted share on a GAAP basis in the December-ending fourth quarter of 2010, down 71 percent from $0.51 in the same three months of 2009. 

Perhaps more significantly, non-GAAP earnings rose 23 percent, from $0.85 to $0.93 per share.  The non-GAAP results exclude various special and non-cash items, including restructuring charges, asset impairments, and legal settlements.

Please note that Watson's acquisition of Arrow Group in December 2009 complicates year-to-year comparisons of the company's 2009 and 2010 results.

This post examines Watson's Income Statement for the latest quarter and compares the entries on each line to our "look-ahead" estimates.  Reported GAAP earnings were far less than the $0.55 per share we had forecast.  Non-GAAP results beat our $0.81 estimate for adjusted cash earnings by $0.12 per share.

The principal sources for this 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.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Watson Pharmaceuticals, Inc., produces and distributes generic and, to a lesser extent, branded pharmaceuticals.  Watson earned $184 million in 2010, down from $222 million in 2009.  Revenue increased from $2.8 billion to $3.6 billion.

The company's market value is currently about $7.0 billion on a fully diluted basis.  It was less than half this amount in early 2009.

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 be better postured to compete against generic giants Teva and Mylan (NYSE: MYL). 

Watson's business is divided into three segments: Global Generics, Global Brands and Distribution.  Global Generics contributed 65.6 percent of Revenue in 2010 and 87.5 percent of allocable operating income. 

Global Brands has numerous pharmaceutical products, with several in Women's Health and Urology markets.  This business yielded 11.1 percent of Watson's Revenue, but only 7.4 percent of operating income in 2010.

New sales have helped offset revenue lost due to the termination in December 2009 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 23.3 percent of Revenue and 5.2 percent of operating income in 2010.

Please click here to see a 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 in the December 2010 quarter increased $167 million (21 percent), from $786 million in 2009 to $953 million in the most recent three months.  The Arrow Group acquisition was responsible for an undisclosed, probably substantial, part of the Revenue increase.  (Arrow's Revenue as a stand-alone business was approximately $130 million per quarter during the first nine months of 2009.) 

Watson's reported revenue surpassed our $900 million estimate by 5.9 percent. 

Full-year Revenue of $3.57 billion exceeded the company's $3.5 billion guidance by 1.9 percent.

Revenue from Watson's Global Generics business in the fourth quarter increased from $467 million to $646 million, a 38 percent rise.  Watson credited the increase to "the addition of our international business [due to Arrow] and new products."

Global Brands revenue fell 14.6 percent, from $121 million to $103 million.  The decrease resulted from the termination last December of a supply and distribution agreement with Sanofi-Aventis (NYSE: SNY) involving Ferrlecit.  Increased sales of other products cushioned the negative effects of the Ferrlecit loss.

Distribution revenue increased a modest 3 percent, from $197 million to $203 million.  The Distribution business sells products other than those made by Watson itself.

Watson's overall Cost of Goods Sold increased to $511 million (53.7 percent of Revenue) from $461 million in 2009's fourth quarter.  The latest amount translates into a Gross Margin of 46.3 percent, which is an impressive 500 basis points more profitable than last year. 

The latest Gross Margin was 130 basis points better than the 45.0 percent we had estimated.

The Generics, Brands, and Distribution businesses achieved Gross Margins of 51.2 percent, 80.3 percent, and 13.7 percent, respectively.  

The charge for Depreciation and Amortization increased from $26.5 million to $52.0 million, which was 4 percent more than our $50 million estimate. The higher charge resulted from the amortization of assets acquired with Arrow.

Research and Development expenses increased 64 percent, from $60.5 million to $99.0 million.  We had expected $73 million.  A $17 million licensing payment and adjustments related to a deal with Columbia Labs may explain why R&D spending was higher than projected.

As a percentage of Revenue, the R&D expense rose from 7.7 percent to 10.4 percent.

Sales, General, and Administrative costs, exclusive of a $40 million litigation reserve charge, rose from $137 million to $166 million. This expense was 3.7 percent more than the $160 million we estimated.

In addition to the aforementioned $40 million litigation reserve charge, which was reported under SG&A, Watson also had a $29.6 million charge for losses on asset sales and impairments. 

Subtracting the various operating expenses from Revenue yields Operating Income of $55 million, down 45 percent from $100 million in the year-earlier quarter.  Operating Income was approximately $125 million excluding the litigation and impairment charges.  This latter figure barely topped our $122 million estimate.  On this basis, the greater-than-expected Revenue outweighed higher R&D spending.

Various non-operating items resulted in a net expense of $23 million, which was a few million more than we expected.  The charge for interest expenses was up significantly.

The effective Income Tax Rate in the quarter was 46.4 percent, significantly more than normal.  We had expected rate of 35 percent.  The legal charge, which was probably not deductible, could have inflated the tax rate.

Bottom-line GAAP Net Income of $18.3 million ($0.15 per share) was roughly 70 percent less profitable than last year's $57 million ($0.51 per share) and substantially below our Net Income estimate of $68.3 million ($0.55 per share).  However, special items in the quarter cloud this view of the company's financial performance.

Backing out special and non-cash items, non-GAAP earnings were $116.5 million ($0.93 per share), up from $94.4 million ($0.85 per share).  Non-GAAP earnings bettered our $101 million ($0.81 per share) projection for non-cash earnings by roughly 15 percent.

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

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