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.
When we earlier analyzed Watson's first quarter results, the Overall Gauge score decreased to 48 of 100 possible points from a more robust 56 points three months earlier. Of the four individual gauges that fed into March's composite result, Profitability was strongest at 15 of 25 points, and Cash Management was weakest at 10 points. The Cash Management score was negatively impacted by rising Inventory levels.
Now, with this available data for the June quarter, our gauges display the following scores:
- Cash Management: 15 of 25 (up from 10 in the first quarter)
- Growth: 8 of 25 (down from 11)
- Profitability: 15 of 25 (unchanged)
- Value: 15 of 25 (up from 11)
- Overall: 56 of 100 (up from 48)
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) | | June 2008 (actual) | June 2008 (predicted) | June 2007 (actual) |
| Revenue | | 623 | 630 | 603 |
| Op expenses | | | | |
| | CGS | (360) | (375) | (360) |
| Depreciation | (20) | (20) | (44) | |
| | R&D | (39) | (40) | (36) |
| | SG&A | (104) | (110) | (97) |
| Other | (0) | (0) | (0) | |
| Operating Income | | 99 | 85 | 66 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | (3) | (4) | (8) |
| Pretax income | | 96 | 81 | 57 |
| Income tax | | (36) | (30) | (21) |
| Net Income | | 60 | 51 | 36 |
| | | $0.51 | $0.44/sh | $0.31/sh |
| Shares outstanding | | 117.7 | 117.4 | 117.1 |
Watson's Generic and Brand product segments posted Revenue increases, but the Distribution segment's Revenue declined 13 percent. Watson attributed the decline to "fewer new product launches in the quarter." The Distribution segment sells products other than those made by Watson itself.
The Gross Margin for the quarter, at 42.2 percent of Revenue, beat our 40.5 percent target. This translates into a Cost of Goods Sold (CGS) of 57.8 percent of Revenue.
Depreciation was 3.2 percent of Revenue, in line with the forecast. The guidance from Watson to expect $80 million in annual Depreciation and Amortization expenses is accurate so far this year.
Research and Development (R&D) expenses were 6.3 percent of Revenue. This value was also very consistent with company guidance. Sales, General, and Administrative (SG&A) expenses were 16.8 percent of Revenue, compared to the forecast of 17.5 percent.
The greater-than-expected Gross Margin and the lower-than-expected SG&A expense more than made up for the slight Revenue shortfall. As a result, Operating Income exceeded our prediction by a healthy 16.5 percent.
Net Interest Expense was $1 million less than we expected. Our target for the Income Tax Rate was 37 percent, and the actual rate was 37.1 percent. Net Income, therefore, exceeded our estimate by 17.6 percent.
Cash Management. This gauge increased from the 10 points in March to 15 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 2.9 | 2.7 | 2.4 |
| LTD/Equity | 41.8% | 43.3% | 55.2% |
| Debt/CFO | 2.1 yrs | 2.0 yrs | 2.1 yrs |
| Inventory/CGS | 131 days | 127 days | 109 days |
| Finished Goods/Inventory | 67.7% | 70.0% | 65.5% |
| Days of Sales Outstanding (DSO) | 44.2 days | 48.3 days | 50.7 days |
| Working Capital/Market Capitalization | 20.4% | 17.1% | 13.3% |
| Cash Conversion Cycle Time | 67.8 days | 76.3 days | 80.2 days |
The big increase in Working Capital was the predominant reason for the score increase, but the nice decrease in Days of Sales Outstanding helped as well. We continue to be troubled by the increase in Inventory, but we aren't sure whether it reflects changing product demand or a different sales mix.
Growth. This gauge decreased from 11 points in March to 8 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 5.8% | 9.3% | 33.8% |
| Revenue/Assets | 70.8% | 71.3% | 67.0% |
| CFO growth | -16.9% | -4.3% | 38.4% |
| Net Income growth | N/A | N/A | N/A |
Revenue/Assets is much higher than historical averages, but we need to remember that this reflects the company's increasing dependence on high-volume generic drugs. We remain concerned about the fading Cash Flow from Operations.
Profitability. This gauge didn't change from 15 points in March.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 87.7% | 89.0% | 91.3% |
| ROIC | 7.5% | 6.6% | 4.5% |
| FCF/Equity | 16.5% | 17.3% | 23.3% |
| Accrual Ratio | -4.4% | -5.3% | 15.6% |
Operating expenses have edged down because the Gross Margin has improved. 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. Watson's stock price decreased during the quarter from $29.32 to $27.17. The Value gauge, based on the latter price, rose to 15 points from 11 points three months ago.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 17.4 | 21.5 | N/A |
| P/E to S&P 500 average P/E | 98% | 125% | N/A |
| Price/Revenue | 1.3 | 1.4 | 1.6 |
| Enterprise Value/Cash Flow (EV/CFO) | 9.5 | 10.1 | 9.9 |
An Overall gauge score of 56, of 100 possible, points is a good result, and it suggests that Watson deserves increased attention. We would still like to see lower Inventory levels, higher CFO, and better ROIC.
Posts
No comments:
Post a Comment