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Watson Pharmaceuticals, Inc. (NYSE:WPI) recently announced its acquisition of Andrx Corp., a pharmaceutical company that has many generic offerings. Many have suggested that this is a crucial move for Watson, which has seen its profit margins shrinking over the past year. While Watson will only enjoy about two months of Andrx revenues in 2006, the company hopes the acquisition will give it some economies of scale and improve profitability in the coming years.

Watson is the third largest company in the generic business, and it also has several branded products, particularly for bladder problems, pain relief and anemia. These products haven't been doing as well of late, however, so revenue growth has come primarily from its lineup of generics.

This could be a problem for Watson going forward: while it can continue to offer more generics as patents expire in coming years, competition has driven down pricing in the generic market, which is a big reason why profit margins haven't been so strong lately. There's been talk since election day that the Democratic Congress will push to limit patents and make generics more accessible. While this may help, it may also end up being canceled out if the Dems, as expected, revise the Medicare bill to allow the government to negotiate drug prices for Medicare.

A company like Watson may be hardest hit by these changes. It has to maintain its research and selling costs, but it's not big enough to spread out these costs. (It's main rivals in the generics industry, Teva and Sandoz, Inc. are four times as large.) Nor is it small enough to be content focusing on a few niche markets.

While I think Watson is a solid company, I think the waters are too uncertain to be a safe pick right now.

Type of stock: A medium-sized pharmaceutical company that makes most of its money off generic drugs.

Price Target: At $25, Watson is closer to the low end of its 52-week range. It bottomed out during the summer and has bounced back a bit, but I don't see enough hope in the Andrx acquisition to recommend buying right now.

WPI 1-yr chart:

WPI chart

Source: Watson Pharmaceuticals: Don't See The Miracle Cure