04 August 2007

WPI: Financial Analysis through June 2007

We have analyzed Watson Pharmaceuticals' (WPI) preliminary financial results for the quarter that ended on 30 June 2007. Our evaluation will be updated after the company formally submits a complete 10-Q report to the SEC.

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.

Investors collectively realized this year that many branded pharmaceutical products will soon lose their patent protection. When they did, stocks of generic drug manufacturers become a lot more attractive.

When we analyzed Watson after the March quarter, the Overall score was an encouraging 48 points. Of the four individual gauges that fed into this composite result, Growth and Profitability were strongest at 16 points each. Cash Management was weakest at 7 points. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the June 2007 quarter, our gauges display the following scores:


Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.


($ M)
June 2007
(actual)
June 2007
(predicted)
 June 2006
(actual)
Revenue
603
 650
 510
Op expenses




CGS (360)
(419)
 (331)

Depreciation
(44)
(46)
(41)

 R&D (36)
(39)
 (311)

SG&A (97)
 (104) (71)

Other
0
0
(67)
Operating Income
66
 42
 (30)
Other income




Investments
 0
 0
 0

Interest, etc.
 (8)
 (5)
 5
Pretax income
57
 37
 (25)
Income tax
21
14
 (10)
Net Income
36
 23
 (15)


0.31/share
 0.20/sh
 (0.15)/sh





Revenue was 7.2 percent below our estimate. We're still puzzled why revenue in the March 2007 was so high, $672 million, which led to us aiming way too high in the recent quarter. We expected Revenue to be an acquisition fueled 27.5 percent greater than in the year-earlier quarter, and the actual increase was a still-healthy 18.2 percent. (Forecasts after a major acquisition are especially challenging.)

Watson made excellent progress increasing their Gross Margin. We thought the Cost of Goods Sold (CGS) would be 64.5 percent of Revenue, and the actual value was 59.7 percent. Depreciation was 7.3 percent of revenue, compared to our 7.0 percent estimate. Research and Development (R&D) expenses were 6.0 percent of Revenue, exactly matching our estimate. Similarly, Sales, General, and Administrative (SG&A) expenses were 16.1 percent of Revenue, compared to our forecast of 16 percent.

Although we significantly underestimated revenue, Watson's progress on the cost side of the equation was so much better than we expected that it led to Operating Income 57 percent above the forecast value.

Non-operating expenses were a small $3 million greater than expected. The Income Tax Rate matched our 37 percent prediction. Net Income, driven by operating income, also exceeded our prediction by about 57 percent.


Cash Management. This gauge increased from 7 points in March to 9 points now.

The measures that helped the gauge were:

The measures that hurt the gauge were:

Growth. This gauge increased from 16 points in March to 17 points now.

The measures that helped the gauge were:
  • Revenue growth = 34 percent yr/yr, up from 6 percent in a year
  • Revenue/Assets = 67 percent, up from 55 percent in a year; it's not surprising that more high-volume generic drugs in the product mix would have this positive effect on sales efficiency
  • CFO growth = 38 percent yr/yr, up from -12 percent in a year

The measures that hurt the gauge were:
  • 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. Coincidentally, this gauge also increased from 16 points in March to 17 points now.

The measures that helped the gauge were:
  • FCF/Equity = 23.4 percent, up from 13.3 percent in a year
  • Accrual Ratio = -23 percent, down from -7 percent in a year. Although negative values for this ratio are good, we're not used to value that this much negative. We need to explore this.
  • ROIC = 9.3 percent, mediocre but up from 5.7 percent in a year

The measures that hurt the gauge were:
  • Operating Expenses/Revenue = 91 percent, up from 89 percent in a year. This is also a consequence of the more lower-margin generic drugs in the product mix.

Value. Watson's stock price rose over the course of the quarter from $26.43 to $32.53. The Value gauge, based on the latter price, dropped to 7 points, compared to 10 points three months ago (and 11 points twelve months ago).

The measures that helped the gauge were:

The measures that hurt the gauge were:

The average P/E for the Biotechnology and Drugs industry is 28. The average Price/Revenue for the industry is 8.


This was a very good quarter for Watson, primarily because it jacked up the Gross Margin. In addition, the measures of operating efficiency improved nicely. The gauge scores show these improvements, with the exception of Value. The negative trailing-year Net Income caused by the $500 million charge related to the Andrx deal throws the Value gauge out of whack.

However, what if, for the sake of the argument, the $500 million magically disappeared from Watson's financial history? The P/E ratio would be an expensive 34, and it would not help the Value gauge all that much. Watson is doing much better, but we still need to make sure we don't overpay for growth.
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