Watson develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products. In November 2006, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. [More than a quarter of this cost was later expensed as "in-process R&D."] Andrx made and distributed generic drugs, often controlled-release versions. Watson had been expanding beyond generic drugs into higher-margin branded pharmaceuticals. However, the Andrx acquisition reversed this strategy, and generics became responsible for over 75 percent of revenues.
Across the industry, it's clear that many branded pharmaceutical products will soon lose their patent protection. This situation increases the attractiveness of generic drug manufacturers.
When we analyzed Watson after the September quarter, the Overall score was a modest 41 points. Of the four individual gauges that fed into this composite result, Profitability was strongest at 15 points. Value was weakest at 6 points.
Now, with the available data from the December 2007 quarter, our gauges display the following scores:
- Cash Management: 15 of 25
- Growth: 13 of 25
- Profitability: 12 of 25
- Value: 13 of 25
- Overall: 51 of 100
Please also note that the presentation format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($ M) | | Dec 2007 (actual) | Dec 2007 (predicted) | Dec 2006 (actual) |
| Revenue | | 627 | 630 | 621 |
| Op expenses | | | | |
| | CGS | (373) | (366) | (410) |
| Depreciation | (44) | (44) | (42) | |
| | R&D | (36) | (41) | (41) |
| | SG&A | (108) | (112) | (102) |
| Other | (0) | (0) | (501) | |
| Operating Income | | 66 | 67 | (476) |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | (6) | (7) | (6) |
| Pretax income | | 60 | 60 | (481) |
| Income tax | | (21) | 22 | (8) |
| Net Income | | 38 | 38 | (489) |
| | | $0.33/sh | 0.33/sh | (4.80)/sh |
| | | | |
Revenue in the January 2008 quarter was 1.0 percent more than in the year-earlier quarter. It was just shy of our estimate, which was based on the company' guidance to expect Revenue of $2.5 billion for the entirety of 2007.
We expected the Cost of Goods Sold (CGS) to be 58.0 percent of Revenue, and the actual value was 59.5 percent for a Gross Margin of 40.5 percent. Depreciation was 7.0 percent of Revenue, in line with our forecast. Research and Development (R&D) expenses were 5.7 percent of Revenue, an iota less than our 6.0 percent estimate. Sales, General, and Administrative (SG&A) expenses were 17.3 percent of Revenue, compared to the forecast of 17 percent.
With both Revenue and Operating Expenses consistent with expectations, it's no surprise that Operating Income nearly matched the prediction.
The Non-Operating side was also free of surprises, although the Income Tax Rate was a little less than we expected. Our target was 37 percent, and the actual rate was 35.8 percent. The difference was not significant enough to throw off our Net Income estimate.
Cash Management. This gauge increased from 10 points in September to 15 points now.
The measures that helped the gauge were:
- Current Ratio = 2.6; up from 1.8 in December 2006
- Days of Sales Outstanding (DSO) = 47.6 days, much less than the 66.3-day level one year earlier
- Cash Conversion Cycle Time (CCCT) = 54.4 days, down from 93.7 days, for this measure of efficiency
- LTD/Equity = 48.6 percent, down from 66.9 percent last year in the wake of the Andrx deal.
- Working Capital/Market Capitalization = 17.8 percent, up from 14.7 percent (cash levels that were depleted by the acquisition have recovered)
- Debt/CFO = 2.1 years, compared to 2.5 and 2.6 years 3 and 12 months ago, respectively
- Inventory/CGS = 122.2 days, compared to 117.7 days in December 2006
- Finished Goods/Inventory = 67 percent (estimated), compared to 65 percent one year ago)
Growth. This gauge didn't change from 13 points in September.
The measures that helped the gauge were:
- Revenue growth = 26.1 percent year-over-year, up from 20.2 percent
- Revenue/Assets = 72.1 percent, up from 52.6 percent in a year; it's not surprising that more high-volume generic drugs in the product mix would improve sales efficiency
- CFO growth = -9.4 percent year-over-year, disappointing.
- Net Income growth was N/A because the enormous $500 million charge at the end of 2006 for in-process R&D causes net income for the trailing four quarters to be negative.
Profitability. This gauge decreased from 15 points in September to 12 points now.
The measures that helped the gauge were:
- FCF/Equity = 19.0 percent, down from 25.4 percent in a year
- Accrual Ratio = -6.1 percent, up from -23.2 percent in a year.
- ROIC = 6.1 percent, rather tepid up from 5.7 percent in a year
- Operating Expenses/Revenue = 90.0 percent, too high historically, but down from 92.6 percent in a year.
Value. Watson's stock price dropped over the course of the quarter from $32.40 to $27.14. The Value gauge, based on the latter price, rose to 13 points from only 6 points three months ago (and 11 points twelve months ago).
The measures that helped the gauge were:
- Price/Revenue ratio = 1.3, about the same as one year ago and lower than its median of 2.2.
- Enterprise Value/Cash Flow = 9.1, down from a five-year median of 11.4
- P/E = 22.6 (the median P/E is around 27)
- P/E to S&P 500 average P/E = 37 percent premium (the median is 44 percent premium)
The average P/E for the Biotechnology and Drugs industry is 28. The average Price/Revenue for the industry is 7.2.
With the acquisition of Andrx Corporation fading into the rear-view mirror, an Overall Gauge score over 50, and shares that have declined with the market, Watson is worthy of further attention. We would like to see lower Inventory levels, higher CFO, and better ROIC.
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