WPI: Look Ahead to September 2008 Quarterly Results

When we analyzed the second-quarter financial statements of Watson Pharmaceuticals, the GCFR Overall Gauge score advanced from 48 to 56 of the 100 possible points. 

Net Income increased by 66 percent, relative to the year-earlier quarter.  This was achieved with improvements to Revenue, the Gross Margin, and lower Depreciation expenses.  Howerver, Revenue growth was slowed by the company's Distribution segment, which markets products other than those made by Watson itself.  Distribution sales fell by 13 percent in the quarter.  Watson attributed the decline to "fewer new product launches in the quarter."

We're nervously watching an uptick in Watson's Inventory, which rose from 109 days, as measured by Cost of Goods Sold (CGS), on 30 June 2007 to 131 days on 30 June 2008.  The proportion of Inventory deemed to be Finished Goods grew from 66 percent to 68 percent.  By historical standards, the Inventory level is not excessive.  However, expanding Inventory can signal slower-than-expected sales.  Or, more positively, the company might be getting ready to launch a new product.

Our attention is now turned towards Watson's results for the nearly complete third quarter of 2008.

Watson Pharmaceuticals, Inc. (WPI) develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products.  Watson had been expanding beyond generic drugs into higher-margin branded products.  However, Watson's acquisition of Andrx in late 2006 reversed this strategy, and generics are now responsible for three times as much Revenue as branded products.  Watson's management may have deliberately increased their generic drug exposure to take advantage of the large number of branded pharmaceutical products that have, or will soon, lose their patent protection.

The Andrx acquisition, for $1.9 billion in cash, distorted year-to-year comparisons throughout 2007.  However, this big purchase is now fading into the rear-view mirror, and we're hoping to get a better handle on Watson's finances.

On 6 November 2008, Watson is scheduled to announce its third-quarter results.  In anticipation of this report, we've modeled the company's Income Statement for the quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

When the company announced its second-quarter results, it also revised its guidance for the full year.

For the top-line, management estimated that Revenue in 2008 would be approximately $2.5 billion, which would represent zero growth over 2007.  Revenue in the first two quarters was $623 and $627 million -- both remarkably close to 25 percent of the expect annual total.  We have no reason to expect third-quarter Revenue will stray far from the $625 million bogey.


The company didn't provide a forecast for Gross Margin. We will, after looking at historical data, assume Watson will achieve a margin equal to 41 percent of Revenue.  Therefore, our estimate for the Cost of Goods Sold (CGS) in the third quarter is (1 - 0.41) * $625 million, which equals $369 million.

Watson stated that 2008's Amortization expense is expected to be $80 million.  In the first half of the year, this expense was right on track at $40 million.  We will look for another $20 million in the third quarter. 

The company forecast Research and Development expenses for 2008 at $160 million.  These expenses through June were $77.2 million, slightly under the halfway figure.  We will look for $41.4 million of R&D in the third quarter.

Watson also predicted this year's Sales, General, and Administrative expenses to be between $420 to $440 million.  The first-half expense was on track at $211 million.  We will set the third quarter target for SG&A at $109.5 million, to bring the results towards the middle of the guidance range.

These estimates would result in an Operating Income of $85 million, up 52 percent from $56 million in the September 2007 quarter.

Watson's non-operating income and expenses are typically minor.  Lacking specific guidance, we'll assume a $4 million net expense.  This would lead to Income before Taxes of $81 million.

With a 37 percent Income Tax Rate, Net Income will be $51 million ($0.44/share) for the quarter.  This is consistent with Watson's increased guidance for GAAP earnings in 2008 to be between $1.90 to $2.00 per diluted share.  Our estimate is 47 percent above Net Income in 2007's third quarter.

Please note that the table 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)		September 2008 (predicted)	September 2007 (actual)
Revenue		625.0	594.7
Op expenses
	CGS	(368.8)	(346.4)
	Depreciation	(20.0)	(44.2)
	R&D	(41.4)	(35.7)
	SG&A	(109.5)	(112.5)
	Other	(0)	(0)
Operating Income		85.4	56.0
Other income
	Investments	0	6.1
	Interest, etc.	(4.0)	(6.7)
Pretax income		81.4	55.4
Income tax		(30.1)	(20.8)
Net Income		51.3	34.6
		$0.44/sh	$0.29/sh
Shares outstanding		117.8	117.4