In November 2006, after resolving an FTC challenge, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. Andrx was both a maker of generic drugs (often controlled-release versions) and a distributor. Watson had been expanding beyond its roots a generic drug manufacturer into higher-margin branded pharmaceuticals. However, the Andrx acquisition increased Watson's concentration on generics, which are now responsible for over 75 percent of revenues. In addition, $497.8 million, more than 25 percent of the cost of buying Andrx, was classified as "in-process R&D" and expensed in its entirety during the fourth quarter of 2006.
When we analyzed Watson after the quarter that ended in September 2006, the Overall score was a weak 23 points. Of the four individual gauges that fed into this overall result, Cash Management was the strongest at 9 points. Value was weakest at 4 points.
We have since updated the analysis to incorporate Watson's financial results, as reported in a Form 10-K for the full year and fourth quarter, which concluded on 31 December 2006. Our gauges now display the following scores:
- Cash Management: 4 of 25
- Growth: 8 of 25
- Profitability: 16 of 25
- Value: 6 of 25
- Overall: 29 of 100
Cash Management. This gauge dropped 5 points from 9 to 4. The cash spent on Andrx cut the Current Ratio to 1.8, which isn't low enough to cause concerns, from over-stuffed values over 4.0. The acquisition also pushed Long-Term Debt/Equity to a leveraged 67 percent (the average for the industry is 49 percent), up from 26 percent the previous quarter. Inventory/Cost of Goods Sold soared to 153 days, from 111 days at the end of the prior quarter and 119 days at the end of December 2005. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is 65 percent, which is higher than the typical level for the company. If the acquisition hadn't made comparisons difficult, the inventory data would suggest sales were less than expectations. Accounts Receivable/Revenues equal 71 days. This is higher than the prior quarter, but a few days less than the figure from December 2005. There's no indication at the current time the company is finding it more difficult to get its customers to pay their bills.
Growth. This gauge increased 3 points from October. The last two months of the year, which included results from Andrx, pushed Revenue growth to 20 percent year over year, up from no growth a year ago. Net Income growth was N/A because the massive in-process R&D charge swung net income to a net loss. Net income was positive in 2005, but lower than 2004. CFO growth is now an impressive 45 percent, up from 6 percent a year ago. Revenue/Assets is 53 percent; it managed to hold steady despite the acquisition adding to the numerator and denominator. It indicates that the acquisition didn't affect the company's efficiency at generating sales.
Profitability. This gauge increased 4 points from the prior quarter. ROIC slipped to a weak 6 percent from 7 percent a year ago -- we need to calculate Watson's weighted average cost of capital to demonstrate the weakness of this result. Other hand, FCF/Equity jumped up to 25 percent from 12 percent. Operating Expenses/Revenue moved up in the last year from 93 percent to 85 percent. The change was primarily due to a substantial 10 percent decline in Gross Margin (acquisition expenses?), which was slightly ameliorated by other changes. The Accrual Ratio, which we like to be both negative and declining, plunged to an unbelievable -23 percent from -3 percent. However, the value isn't credible because of the large non-cash asset impairment charge.
Value. This gauge, based on the stock price of $26.03 at the year's end, edged up to a weak 6 points from an even weaker 4 points three months ago and 1 point twelve months ago, respectively. It is noteworthy that the score is entirely determined by Price/Revenue. This ratio, which isn't affected by the one-time factors that cause wide swings in earnings, declined to 134 percent from 171 percent in September and 230 percent in December 2005. The decrease suggests the shares have become less expensive. The average Price/Sales for the industry is 875 The P/E and the PEG ratio are not applicable because earnings were negative.
Now at a weak 29 out of 100 possible points, the Overall gauge tells a mixed story. Sales and CFO is strong, but Inventory levels are high and Net Income was torpedoed by acquisition expenses. The company appears cheap on the basis of Price/Revenue, but our other valuation metrics aren't applicable until real earnings are produced. Our greatest worry is that Gross Margin will remain weak because generic drugs are essentially commodities. The ROIC needs to be much higher to keep up with the company's expanded debt levels. We look forward to seeing future financial statements to determine how well the company is digesting Andrx and executing its business strategy.
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