WPI: Financial Analysis through September 2008 (Update)

The press release issued by Watson Pharmaceuticals announcing results for the third quarter contained a somewhat condensed Balance Sheet.  Inventory, current liabilities, and stockholder's equity were items in which details were omitted.  When GCFR analyzed the data and computed gauge scores, we had to fill the data gaps with estimates.

Watson Pharmaceuticals, Inc. (NYSE: WPI) develops, manufactures, and distributes generic and, to a lesser extent, branded pharmaceutical products. 

Watson has now submitted a 10-Q report that includes a current version of each financial statement with appropriate footnotes.  We updated our analysis to address the latest information, and this post identifies the revisions. 

The 10-Q did not alter our examination of Watson's third-quarter Income Statement.  The 10-Q did, however, confirm that the sale of Watson's 50-percent interest in Somerset Pharmaceuticals to Mylan Labs (NYSE: MYL), for a gain of $8.25 million, was the main reason Non-operating Income was unexpectedly high.

Our Balance Sheet estimates were accurate enough that the actual data in the 10-Q didn't change any gauge scores from the figures identified in the original analysis.  The scores are repeated here:

• 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)
  

The GCFR standard practice is to compute the Value gauge using the share price at the end of the subject quarter.  On 30 September, the closing price of Watson shares was $28.50, which translated into the reported 14 points on the Value gauge.  However, by the end of October, the share price had dropped to $26.17.  The lower price per share would add 4 more points to the Value gauge, lifting the score to 18 points.  This increase would bring the Overall gauge up to a solid 58 points.

The following table shows how October's price drop affected the Value metrics:

Value	October 2008	September 2008	June 2008	September 2007
Share Price	$26.17	$28.5	$27.17	$32.40
P/E	14.0	15.3	17.4	N/A
P/E to S&P 500 average P/E	83%	91%	95%	N/A
Price/Revenue	1.2	1.3	1.3	1.5
Enterprise Value/Cash Flow (EV/CFO)	8.7	9.3	9.5	11.9
Gauge Score (0 to 25)	18	14	15	6

There is much other interesting information in the 10-Q.

Inventory levels are something we watch at Watson and similar firms.  The red line on the figure shows that the number of days of Inventory was on a long decline (i.e., efficiency in use of cash was improving), but the number has rebounded somewhat.  The blue line represents the percentage of the Inventory that constitutes finished good, ready for sale.  We consider it more advantageous when the percentage is low and getting lower.  Neither is true at the current time at Watson.  Declining percentages suggest that sales were greater than management expected.

Approximately $16.6 million (3.4 percent) of Watson's $482 million Inventory at the end of the third quarter is associated with products that haven't yet entered the marketplace for regulatory or contractual reasons.

Last year, Watson used an interest rate swap to convert $200 million of floating-rate debt to fixed-rate debt.  The swap expires in January 2009.  The counter-party in this arrangement is not identified.