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Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.57 per diluted share on a GAAP basis in 2010's second quarter, which ended 30 June. Earnings per share increased 28 percent when compared to the $0.45 Watson made in the same quarter of 2009.

Adjusted, non-GAAP earnings rose from $0.73 to $0.83 per share, up 22 percent from the June 2009 quarter. The adjustments exclude non-cash items, such as amortization and asset impairments.

Products obtained when Watson acquired Arrow Group in December 2009 boosted the 2010 results but are not reflected in the 2009 figures.

This post examines Watson's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates. Reported earnings were $0.03 more than the $0.54 per share we had forecast.

The principal sources for this income statement analysis were the earnings announcement and the ensuing conference call (transcript available from Seeking Alpha).

In a second article, we will report Watson's scores as measured by the GCFR financial gauges. The follow-up post will also provide the latest figures for the various financial metrics we use to Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Watson Pharmaceuticals, Inc., produces and distributes generic and, to a lesser extent, branded pharmaceuticals. Watson earned $222 million in 2009, down from $238 million in 2009. Revenue increased from $2.5 billion to $2.8 billion. The company's current market capitalization is approximately $5.5 billion.

The Arrow Group acquisition augmented Watson's portfolio of generic drugs and expanded the company's access to international markets. Arrow was not Watson's first large acquisition: it purchased Andrx in late 2006. The company also obtained 15 drugs in 2008 from Teva Pharmaceutical (NASDAQ: TEVA).

Additional background information about Watson and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the quarterly Income Statements for the last couple of years. Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats. The standardization facilitates cross-company comparisons.


Revenue in the June quarter increased $197.5 million or 29.1 percent, from $677.8 million last year to $875.3 million in the most recent three months. The Arrow Group acquisition is responsible for a substantial, but undisclosed part, of the Revenue increase. (Arrow's Revenue as a stand-alone business was approximately $130 million per quarter during the first nine months of 2009.)

Watson's reported revenue exceeded our $870 million estimate by a tiny 0.6 percent. With half the year complete, the company has now logged 49.5 percent of its $3.5 billion Revenue guidance for the full year.

Revenue from Watson's Global Generic business rose from $401.2 million to $571.0 million, a 42 percent increase. Watson credited the increase to sales outside the U.S. (due to Arrow), new products such as metoprolol succinate extended-release tablets, and stronger sales (up 12 percent) of oral contraceptives.

Global Brand revenue fell from $115.3 million to $103.5 million, a 10.2 percent decline. The decrease resulted from the termination last December of a supply and distribution agreement with Sanofi-Aventis (NYSE: SNY) involving Ferrlecit. The decline in product sales was mitigated partially by increased licensing revenue. Increases in prescriptions issued for RAPAFLO and Gelnique also helped.

Distribution revenue increased a robust 24.5 percent. This business segment sells products other than those made by Watson itself. The company stated that the Revenue increase was primarily due to sales of generic products launched since late 2009.

Watson's overall Cost of Goods Sold increased to $498 million (56.9 percent of Revenue) from $393 million in 2009's second quarter. The latest amount translates into a Gross Margin of 43.1 percent, which is 110 basis points more profitable than last year. Watson attributed the improved gross margin to product mix changes, lower manufacturing costs, and higher production levels.

Although up from last year, the Gross Margin was 90 basis points less than the 44.0 percent we had estimated. Sales of high-margin branded pharmaceuticals were a little less than expected, and revenue from low-margin product distribution was greater than anticipated.

The Generic, Branded, and Distribution businesses achieved Gross Margins of 46.4 percent, 77.2 percent, and 16.1 percent, respectively.

The charge for Depreciation and Amortization increased from $22 million to $43 million, a little more than our $41 million estimate. The higher charge resulted from the amortization of product rights acquired with Arrow.

Research and Development expenses increased 45 percent, from $43 million to $62 million. We had expected $63 million. As a percentage of Revenue, the R&D expense rose from 6.3 percent to 7.1 percent.

Sales, General, and Administrative costs rose from $128 million to $157 million, which was slightly below the $160 million we estimated. SG&A fell from 18.9 percent of Revenue to 17.9 percent.

Subtracting the various operating expenses from Revenue yields Operating Income of $116 million, up 26 percent from $92 million in the year-earlier quarter. The increase was due to higher Revenue and a better Gross Margin.

Operating Income in the latest quarter fell 2.6 percent, a small amount, short of our $119 million target. The Gross Margin, as mentioned above, was modestly lower than we expected because of the sales mix.

Various non-operating items resulted in a net expense of $17.3 million, which was more substantial than the $10 million expense we expected. The charge for interest expenses was up significantly.

It's very significant that the Income Tax Rate was only 28.3 percent, down from 41.5 percent last year. We expected the Income Tax Rate to be 39 percent. Watson stated that the low rate, which helped the company's bottom line, "was due to certain non-recurring tax benefits associated with the Arrow acquisition."

Bottom-line GAAP Net Income of $70.6 million ($0.57 per share) was 33 percent more profitable than last year's $53 million ($0.45 per share). Our Net Income estimate for the most recent quarter was $66.4 million ($0.54 per share). The lower-than-anticipated tax rate was the main reason the reported figure exceeded the estimate. If the income tax rate in the second quarter had simply matched the first quarter's 34.5 percent, and the rest of the Income Statement remained the same, EPS would have been $0.05 less.

Full disclosure: No position in WPI at the time of writing.

Source: Watson Pharmaceuticals: In Depth Analysis for the June 2010 Quarter