Our evaluation was limited because the Balance Sheet in the press release omitted various details, including those characterizing inventory, current liabilities, and stockholder's equity. These omissions are typical in Watson's preliminary reports, and they will certainly be rectified in the 10-Q the company will submit to the SEC.
Watson Pharmaceuticals, Inc. (NYSE: WPI) develops, manufactures, and distributes 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, for $1.9 billion in cash, reversed this strategy. Generics are now responsible for three times as much Revenue as branded products. Watson's management may have deliberately increased their generic drug portfolio to take advantage of the large number of branded pharmaceutical products that have lost or will soon lose their patent protection.
Three months ago, when we analyzed Watson's second-quarter financial statements, the GCFR Overall Gauge score advanced from 47 to 55 of the 100 possible points. Net Income increased by 66 percent, relative to the year-earlier quarter.
The second-quarter results made a little nervous about an uptick in Watson's Inventory, which rose over a 12-month period from 109 days to 131 days, as measured with Cost of Goods Sold (CGS). The proportion of Inventory deemed to be Finished Goods grew from 66 percent to 68 percent. Expanding Inventory can signal slower-than-expected sales or that the company is gearing up for a new product launch.
Now, with the available data for the September quarter, our gauges display the following scores:
- Cash Management: 10 of 25 (down from 15 in June)
- Growth: 2 of 25 (unchanged)
- Profitability: 17 of 25 (up from 15)
- Value: 14 of 25 (down from 15)
- Overall: 53 of 100 (down from 55)
Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.
Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($ M) | | September 2008 (actual) | September 2008 (predicted) | September 2007 (actual) |
| Revenue | | 640.7 | 625.0 | 594.7 |
| Op expenses | | | | |
| | CGS | (386.7) | (368.8) | (346.4) |
| Depreciation | (20.2) | (20.0) | (44.2) | |
| | R&D | (45.3) | (41.4) | (35.7) |
| | SG&A | (101.3) | (109.5) | (112.5) |
| Other | (0) | (0) | (0) | |
| Operating Income | | 87.2 | 85.4 | 56.0 |
| Other income | | | | |
| | Investments | (0.3) | 0 | 6.1 |
| | Interest, etc. | 7.1 | (4.0) | (6.7) |
| Pretax income | | 94.0 | 81.4 | 55.4 |
| Income tax | | (23.0) | (30.1) | (20.8) |
| Net Income | | 71.1 | 51.3 | 34.6 |
| | | $0.60/sh | $0.44/sh | $0.29/sh |
| Shares outstanding | | 118.0 | 117.8 | 117.4 |
Watson's Revenue in the quarter was 7.7 percent more than in the year-earlier quarter. It was also 2.5 percent above the $625 million target that is one-quarter of the company's $2.5 billion Revenue target for the year.
Revenue in the Distribution segment increased 31.6 percent, a powerful rebound after a weak second quarter. Watson attributed the increase to new product launches. The Distribution segment sells products other than those made by Watson itself.
The Cost of Goods Sold was 60.3 percent of Revenue, which translates into a Gross Margin of 39.7 percent of Revenue. We thought the company would achieve a Gross Margin of 41.0 percent, which seemed reasonable given that the margin was 41.7 percent in the year-earlier quarter.
Depreciation and Amortization surpassed the $20 million target by 1.0 percent. The target value is one-quarter of the company's guidance to expect $80 million in Depreciation and Amortization expenses over 2008.
The company spent 7.1 percent of Revenue on Research and Development (R&D). The expense was 9.4 percent more than our prediction, which was based on Watson's guidance to expect R&D expenses of $160 million in 2008. The company chose to accelerate R&D "pipeline activities" for its Generic segment. R&D expenses in the September 2007 quarter were 6.0 percent of Revenue.
Sales, General, and Administrative (SG&A) costs were 15.8 percent of Revenue, compared to 18.9 percent in the year-earlier period. SG&A expenses were $8.2 million less than our estimate, but most of the difference can be explained by a $5.9 million favorable settlement on a matter related to a U.S. federal tax audit. Our prediction was consistent with the guidance to expect annual SG&A expenses between $420 to $440 million.
Operating Income was up a stunning 56 percent from the amount in the September 2007 quarter, but it exceeded our prediction by only 2.1 percent. The better-than-expected performance was the result of a higher Revenue and a lower-than-anticipated SG&A expense.
Total Non-Operating Income was $10.8 million more than we expected. This was mainly due to "Other Income" rising by $10.5 million. We think, but are not positive, that most of this income was related to the sale of the Somerset joint venture to Mylan Labs (NYSE: MYL).
Our target for the Income Tax Rate was 37 percent, and the actual rate was 24.4 percent. The lower rate was due to the resolution of the tax audit and various other one-time measures.
Net Income was more than double the result of the year-earlier quarter, and it exceeded our prediction by 39 percent. While growing Revenue certainly helped, a large amount of this out-performance can be explained by the tax settlement and the sale of joint venture assets.
| Cash Management | September 2008 | 3 mos. ago | 12 mos. ago |
| Current Ratio | 3.3 | 2.9 | 2.8 |
| LTD/Equity | 40.2% | 41.8% | 53.9% |
| Debt/CFO | 2.0 yrs | 2.1 yrs | 2.5 yrs |
| Inventory/CGS | 123 days | 131 days | 100 days |
| Finished Goods/Inventory | N/A | 67.7% | 67.1% |
| Days of Sales Outstanding (DSO) | 42.8 days | 44.2 days | 39.6 days |
| Working Capital/Market Capitalization | 22.1% | 20.4% | 15.2% |
| Cash Conversion Cycle Time | 73.8 days | 67.8 days | 74.0 days |
| Gauge Score (0 to 25) | 10 | 15 | 10 |
The Balance Sheet remains strong. The decrease in Inventory from three months ago is a positive, but it is still much higher than last year. Similarly, decrease in Days of Sales Outstanding from June's level is good, but we'd like to see it lower than in September 2007.
| Growth | September 2008 | 3 mos. ago | 12 mos. ago |
| Revenue growth | 1.1% | 5.8% | 40.2% |
| Revenue/Assets | 71.9% | 70.8% | 74.9% |
| CFO growth | 5.7% | -16.9% | 1.4% |
| Net Income growth | N/A | N/A | N/A |
| Gauge Score (0 to 25) | 2 | 2 | 13 |
The turnaround in Cash Flow from Operations is the one positive on the Growth side of the ledger.
| Profitability | September 2008 | 3 mos. ago | 12 mos. ago |
| Operating Expenses/Revenue | 86.7% | 87.7% | 91.6% |
| ROIC | 8.8% | 7.6% | 4.7% |
| FCF/Equity | 17.8% | 17.4% | 16.1% |
| Accrual Ratio | -3.7% | -4.4% | 18.0% |
| Gauge Score (0 to 25) | 17 | 15 | 8 |
Profitability is has improved greatly. Operating expenses have edged down, and ROIC seems to be recovering from anemic levels. By dropping over the last year, the Accrual Ratio is indicating that more of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, less is due to changes in non-operational Balance Sheet accruals.
| Value | September 2008 | 3 mos. ago | 12 mos. ago |
| P/E | 15.3 | 17.4 | N/A |
| P/E to S&P 500 average P/E | 91% | 95% | N/A |
| Price/Revenue | 1.3 | 1.3 | 1.5 |
| Enterprise Value/Cash Flow (EV/CFO) | 9.3 | 9.5 | 11.9 |
| Gauge Score (0 to 25) | 14 | 15 | 6 |
Watson's stock price increased during the quarter from $27.17 to $28.50. As is the case for most companies, the shares trade for a much lower price today. However, the Value gauge score above is calculated using the quarter-end price, in accordance with GCFR standard practice.
Watson's valuation ratios can be compared with other companies in the Generic Drug industry.
| Overall | September 2008 | 3 mos. ago | 12 mos. ago |
| Gauge Score (0 to 100) | 53 | 55 | 32 |
The Overall gauge score is in encouraging territory. This was result was enabled by improving Profitability and better Value (as the stock price falls.) We look forward to the additional data in the 10-Q to refine our findings.
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