Watson Is Still Strong Despite A Slowing Generic Drug Market

Dec.11.12 | About: Allergan plc (AGN)

The so-called patent-cliff is a two edged sword. Mainly, it's a cliff for big pharmaceutical companies that make branded products to fall off whenever the patents on their branded drugs expire. That's when generic drug makers like Watson (WPI) swoop in with generic products that undercut the brand names with lower prices. This was especially true in 2012 when no less than $35billion worth of brand name drugs had their patents expire. 2013, on the other hand, has an outlook of less half the amount in 2012, at $17 billion. Moreover, this trend is calculated to last for some two years, going well into 2014. So now the patent-cliff, or more accurately the absence of one, threatens big generic pharmaceutical companies such as Watson with greatly diminished revenues from copycat generics.

Watson has anticipated this potential decrease in its revenues and put in motion different strategies to offset fewer opportunities. One of the main strategies adopted is growth and diversification through acquisitions. In fact, Watson acquired another generic drug maker, the Swiss company Actavis, making Watson the third largest generic drug company in the world.

Apart from the advantages of greater size, such as greater economies of scale, the acquisition of Actavis will greatly diversify Watson's geographical reach to sixty countries from the current twenty. Moreover, it will introduce Watson to some of the most dynamic and lucrative emerging markets such as Mexico, Brazil and Russia. In line with a push to be a global company, Watson will also change its name to Actavis - a move that highlights the importance of that particular acquisition.

Actavis brings several advantages to Watson. It is itself a giant generic drug maker, with sales of $2.5 billion in 2011, expected to reach $2.6 billion in 2012. It has more than 1,000 products in the market and over 300 products in the pipeline. Moreover, because of the flexibility of its supply chain, Actavis can turn out different drugs on short notice, something customers surely appreciate.

As part of this growth strategy, Watson has also acquired the Greek generic drug maker Specifar Pharmaceuticals for $417 million and an Australian division of Strides Arcolab Ltd. for $319 million.

Watson is also pursuing another method of copying products called biosimilars. These are copies of the newest drug on markets called biogenics, drugs made out of proteins produced by living cells and used to treat complicated diseases such as cancer and arthritis. These are also particularly hard to copy. To do this, Watson has partnered with Amgen (AMGN) and will invest $400 million to produce generic versions of cancer treating drugs.

Meanwhile Watson has not been complacent about its main business. Capitalizing on the patent expiry windfall in 2011-12, it will make generics of Lidoderm, Seasonique, Concerta, Lovenox, Xopenex and, if the generic version is approved, Loestrin 24 in 2014. It also has some 130 new generic drug applications that are waiting to be approved by the FDA.

Another factor Watson will be able to look forward to is the U.S. health reform law and the pressure to reign in galloping health care costs. This pressure to bring down costs will mean greater demand for less costly generic drugs.

In Q4 2011, revenues went up substantially from Q3 2011 to reach $1.54 billion, almost half a billion more than in Q3 2011. Since then they have been decreasing steadily until Q3 2012 when they reached $1.29 billion. Operating income exhibits a similar pattern, reaching a high of $167 million in Q4 2011 and then decreasing every quarter to reach $89 million in Q3 2012. While net income also reaches a peak in Q3 2011, it exhibits a loss in Q2 2012 of $62 million but then a profit of $77 million in Q3 2012.

Nevertheless, Watson's stock performance has been outstanding. While Watson is trading at around $88, at a pace close to its 52 week high of $90, its performance over the last five years, including the last 52 weeks, has been of a pretty steady upward climb from a $60 range at the beginning of 2012 for a percentage increase of around 30%. In doing so, it has outperformed the Dow Jones Industrial Index and other generic pharmaceuticals such as Teva (TEVA) and Mylan (NASDAQ:MYL) by a wide margin over the last year. Earnings per share over the last four quarters have been $1.28.

Watson clearly has been doing things right up to this point. But perhaps its most significant move has been to expand worldwide, and especially into emerging markets, through its acquisition of Actavis. Also, mature markets like Europe and Japan have not adopted generic drugs to the extent that the U.S. has, so there's room to grow there. All of these factors add up to one convincing situation for Watson investors and steady growth potential across what might be slower market years in generic drug revenue.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was prepared for Freedonia Freelance by one of our analysts.