WPI: Financial Analysis through June 2007 (Updated)

Watson Pharmaceuticals' (WPI) preliminary financial results for the second quarter included a highly condensed Balance Sheet. A more complete version was provided later in the 10-Q the company filed with the SEC. The additional information gave us insight into Watson's inventory, current liabilities, and stockholder's equity.

We used the 10-Q to update our earlier analysis of the results. The gauge scores didn't change appreciably, but some of the individual metrics that propel the gauges were altered by minor amounts. The full revised analysis report is provided below for completeness.


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:

• Cash Management: 9 of 25
• Growth: 17 of 25
• Profitability: 17 of 25
• Value: 7 of 25
  

• Overall: 45 of 100

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 great, $672 million, which led to us aiming too high in the recent quarter. We expected Revenue in the June quarter to be an acquisition-fueled 27.5 percent more 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:

• Current Ratio =2.4; a sign of strength
• Days of Sales Outstanding (DSO) = 51 days, much less than the 65-day level one year earlier
• Cash Conversion Cycle Time (CCCT) = 80 days, down from 87 days, for this measure of efficiency
• LTD/Equity = 55 percent, up from 27 percent last year in wake of the Andrx deal, but already down from last quarter's 63 percent
  

The measures that hurt the gauge were:

• Working Capital/Market Capitalization = 13 percent, down from 40 percent
• Debt/CFO = 2.1 years, compared to 2.5 and 1.7 years 3 and 12 months ago, respectively
  
• Inventory/CGS = 109 days, compared to 102 and 110 days 3 and 12 months ago, respectively
  

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 drops net income for the trailing four quarters into negative territory.
  

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 = 9.2 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:

• Enterprise Value/Cash Flow = 9.9, down from a median of 11.4
• Price/Revenue ratio = 1.6, lower than its median of 2.3
  

The measures that hurt the gauge were:

• P/E = N/A (the median P/E is around 27)
  
• P/E to S&P 500 average P/E = N/A (the median is 48 percent premium)
  

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 charge 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.