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.
On Tuesday, Watson announced that the FDA has completed an inspection of Watson's manufacturing facilities in Florida. The inspection removed a roadblock that was preventing approval of certain new drug manufacturing requests.
The Andrx acquisition, for $1.9 billion in cash, distorts year-to-year comparisons, and we have to be extra cautious as a result. Watson took an enormous $500 million charge for in-process R&D in the immediate aftermath of the acquisition. The results for 2007 appear rosier simply because the year did not include 2006's cash expenditure and write-off.
When we analyzed Watson after 2007's fourth quarter results became available, the Overall gauge score jumped to a solid 56 points on a scale of 0 to 100. Of the four individual gauges that fed into this composite result, the Cash Management, Growth, Profitability, and Value gauges were all between 13 and 15 points.
Our evaluation of the most recent quarter was limited because the Balance Sheet that has been made available omitted various details, including those characterizing inventory, current liabilities, and stockholder's equity. These omissions are typical in Watson's preliminary reports, and they will certainly be rectified in the 10-Q the company will submit to the SEC.
With this caveat, our gauges now display the following scores:
- Cash Management: 15 of 25 (unchanged from December)
- Growth: 11 of 25 (down from 13)
- Profitability: 14 of 25 (down from 15)
- Value: 11 of 25 (down from 13)
- Overall: 51 of 100 (down from 56)
Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.
Please also note that the presentation format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($ M) | | March 2008 (actual) | March 2008 (predicted) | March 2007 (actual) |
| Revenue | | 627 | 600 | 672 |
| Op expenses | | | | |
| | CGS | (380) | (348) | (425) |
| Depreciation | (20) | (20) | (44) | |
| | R&D | (38) | (40) | (38) |
| | SG&A | (107) | (105) | (103) |
| Other | 0 | (10) | (0) | |
| Operating Income | | 82 | 77 | 62 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | (0) | (6) | (10) |
| Pretax income | | 82 | 71 | 52 |
| Income tax | | (31) | (26) | (20) |
| Net Income | | 51 | 45 | 32 |
| | | $0.43 | $0.38/sh | $0.27/sh |
| Shares outstanding | | 117 | 117 | 116.6 |
The biggest factor leading to the Revenue decline, relative to the year-earlier quarter, was the termination of a generic-drug distribution agreement.
We had expected that Watson would achieve a Gross Margin in the first quarter of 42 percent of Revenue, but the actual margin was only 39.4 percent. This translates into a Cost of Goods Sold (CGS) of 60.6 percent of Revenue.
Depreciation was 3.2 percent of Revenue, in line with the forecast. We were skeptical when we first saw guidance from Watson to expect only $80 million in annual Depreciation and Amortization expenses in 2008, less than half the 2007 figure of $176.4 million. However, the first quarter value was fully consistent with management's guidance.
Research and Development (R&D) expenses were 6.1 percent of Revenue, which compares favorably to our 6.7 percent estimate. Sales, General, and Administrative (SG&A) expenses were 17.0 percent of Revenue, compared to the forecast of 17.5 percent.
We allocated $10 million for special operating charges in the first quarter. The company had indicated that it would incur charges in 2008 for a plant closure and for licensing and debt repurchase charges. However, rather than create one or more separate line items for these charges, Watson chose to absorb them into other expense categories.
The greater-than-expected Revenue and the lower-than-expected Gross Margin almost canceled each other out. Good control of other operating expenses tipped the balance toward the positive side. Operating Income exceeded our prediction 6.5 percent.
Net Interest Expense was $6 million less than we expected. Our target for the Income Tax Rate was 37 percent, and the actual rate was 38.1 percent. Net Income still exceed our estimate by 13 percent.
Cash Management. This gauge didn't change from the 15 points achieved in December.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 2.7 | 2.6 | 2.4 |
| LTD/Equity | 43.3% | 48.6% | 62.7% |
| Debt/CFO | 2.0 yrs | 2.1 yrs | 2.5 yrs |
| Inventory/CGS | 127 days | 122 days | 102 days |
| Finished Goods/Inventory | N/A | 69.7% | 62.2% |
| Days of Sales Outstanding (DSO) | 48.3 days | 47.6 days | 51.5 days |
| Working Capital/Market Capitalization | 17.0% | 17.8% | 15.6% |
| Cash Conversion Cycle Time | 74.6 days | 56.9 days | 82.0 days |
Debt spiked after the Andrx acquisition, but the amount has been whittled down. We don't care for the increase in Inventory, but aren't sure whether it reflects changing product demand or a different sales mix. We have to wait for the 10-Q to get inventory composition data.
Growth. This gauge decreased from 13 points in December to 11 points now.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 9.3% | 26.1% | 35.8% |
| Revenue/Assets | 71% | 72% | 63% |
| CFO growth | -4.3% | -9.4% | 19.1% |
| Net Income growth | N/A | N/A | N/A |
The company predicted essentially flat Revenue growth in 2008, which will put a lot of pressure of this gauge. We're concerned that Cash Flow is not a growth story.
Profitability. This gauge decreased from 15 points in December to 14 points now.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 89.0% | 90.0% | 92.3% |
| ROIC | 6.6% | 6.2% | 7.0% |
| FCF/Equity | 17.2% | 19.0% | 21.7% |
| Accrual Ratio | -5.3% | -6.4% | 14.9% |
Operating expenses have edged down because the Gross Margin has improved. ROIC is anemic. 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. Watson's stock price increased during the first quarter from $27.14 to $29.32. The Value gauge, based on the latter price, dropped to 11 points from 13 points three months ago.
| March 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 21.5 | 22.6 | N/A |
| P/E to S&P 500 average P/E | 130% | 127% | N/A |
| Price/Revenue | 1.4 | 1.3 | 1.4 |
| Enterprise Value/Cash Flow (EV/CFO) | 10.1 | 9.1 | 9.6 |
With the acquisition of Andrx Corporation fading into the rear-view mirror, we should be able to get a better handle on Watson's financials. Although down 5 points from December, an Overall Gauge score of 51 is normally considered a decent result. We would like to see lower Inventory levels, higher CFO, and better ROIC.
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