Watson Pharmaceuticals: A Potent Drug Combination

Watson (WPI) develops, manufactures and markets both generic and branded drugs. It also holds a 50% interest in Somerset Pharmaceuticals a joint venture with Mylan Labs (MYL). It previously had acquired Andrx Group in November 2006, bringing its stable of marketed products to over 150 generic and 27 brand name drugs.

After dipping to $1.03 in 2006, the EPS have grown nicely. 2007 saw earnings of $1.37 and 2008 looks to have come in around $2.00. Sales hit a record $2.496 billion in 2007.

WPI has a very nice balance sheet with long-term debt just 30% of capital. Short term debt of $200 million was exceeded by about $352 million in treasury cash as of the end September. Even better, almost the entire long term debt is a 2.1% convertible issue not due to mature until 2023. Convertibility is at $40.05 – 59% above today's quote.

This fine company now trades at just 12.6x last year's earnings versus a 10-year median P/E of 24x. It's also offered at just about 1.25x book value right now. At the two best previous buying opportunities WPI shares were 16x and 11x trailing EPS and 2.5x and 1.2x book value respectively. From those valuation levels (in April 1997 and July 2002) the shares jumped from $16 to $63 and from $18 to $50.10 over the next 12 – 24 months.

Because of the current choppy market, I'm only using a 15 multiple for my year ahead target price of > $30 /share. If you're a believer then here is a wonderful way to play that move with lower risk and higher upside than a straight share purchase by itself.

………………………………………….. Cash Outlay ……….. Cash Inflow

Buy 1000 shares @$25.19 ……………..$25,190

Sell 10 Jan. 2010 $25 Calls @ $4.20 …………………………...$4,200

Sell 10 Jan. 2010 $25 Puts @ $3.60 …………………………....$3,600

Net Cash Out-of-Pocket ………………………….$17,390

If WPI shares are $25 or higher on expiration date (Jan. 15, 2010) [and… they are higher than that price right now]:

• Your shares will be called [sold] for $25,000.
• Your $25 Puts will expire worthless (a good thing for you as a seller).
• You will have no further option obligations.
• You will have $25,000 for your original $17,390 cash outlay.

That's a gain of $7,610 on a cash outlay of $17,390 = + 43.7% on shares which did not have to move up from the day you started.

What's your risk?

If WPI finishes under $25 on expiration date:

• You will be forced to buy an additional 1000 shares @ $25.
• You must maintain sufficient cash or buying power to complete this purchase for the full duration of this trade.
• You would end up owning 2000 shares of WPI.

What's your break even on this trade?

On the original shares it's your cost of $25.19 less the $4.20 call premium = $20.99/share.

On the $25 puts it's the strike price less the put premium = $21.40/share.

Overall then, your average cost would be $21.20/share. That's almost 16% below your starting price.

Disclosure: Author owns shares and is short puts on WPI.

Comments

[claudio.lan...:]

Paul, as you have probably read some of my comments I am a fan. I would like to ask a question about fund allocation if I want to follow your trades for 2009. Perhaps this forum is not the place for that. Can I send the question directly to your email?

Also, this is the first time I have seen the post on maintaining bying power for the WPI trade throughout the trade. Does that apply to all trades of this type?

Jan 07 10:31 AM

[Paul Price:]

Claudio,

You can e-mail me directly at [e-mail]

All puts written require adequate buying power to be in your [margin type] account to be able to sustain your positions. To be safe you should always have quite a bit more buying power than the minimum requirements.

This buying power requrement does not have to be held as cash. It can be met with 'paid up' equity in any marginable securities. That could be shares of stock, T-bills or any other marginable securities you already own and hold in that account.

That is why I speak about cash-on-cash returns when indicating a best case return. If the puts are never exercised the initial outlay is the only cash you need to lay out. The call and put premiums can go towards paying for the shares you are buying.

Jan 07 11:11 AM