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Watson Pharmaceuticals, Inc. (NYSE: WPI) earned $0.21 per diluted share on a GAAP basis in the September-ending third quarter of 2010, down approximately 60 percent from $0.54 in the same three months of last year.

The most recent quarter included a nearly $90 million charge related to a legal settlement involving drug pricing. Excluding certain non-cash items in both periods, adjusted earnings per share rose 9 percent, from $0.78 to $0.85.

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 far less than the $0.59 per share we had forecast. Adjusted cash earnings beat our $0.83 estimate by $0.02 per share.

The principal sources for this income statement analysis were the earnings announcement and the ensuing conference call (transcript available from Seeking Alpha). Please note that products obtained when Watson acquired Arrow Group in December 2009 boosted the 2010 results but are not reflected in the 2009 figures.

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 analyze 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 market value is presently about $6 billion.

The Arrow Group acquisition in December 2009 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).

As a result of these deals, Watson should now be better postured to compete against generic giants Teva and Mylan (NYSE: MYL).

Watson's business is divided for financial reporting purposes into three segments: Global Generics, Global Brands and Distribution. With 170 different products, Global Generics contributed 59.7 percent of Revenue in 2009 and 71.6 percent of allocable operating income.

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 September quarter increased $220 million or 33 percent, from $662 million last year to $882 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 nearly matched our $884 million estimate. With three quarters of the year complete, the company has now logged 74.7 percent of its $3.5 billion Revenue guidance for the full year. It is fair to say Watson's Revenue is hewing closely to expectations.

Revenue from Watson's Global Generic business rose from $398 million to $578 million, a 45 percent increase. Watson credited the increase to sales in new markets outside the U.S. (due to Arrow), new product dosages, and stronger sales of oral contraceptives.

Global Brand revenue fell from $113 million to $100 million, an 11.5 percent decline. The decrease resulted from the termination last December of a supply and distribution agreement with Sanofi-Aventis (NYSE: SNY) involving Ferrlecit. The effect of this termination was mitigated partially by increased sales of other products

Distribution revenue increased a robust 35 percent, from $151 million to $205 million. 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 products launched since late 2009.

Watson's overall Cost of Goods Sold increased to $485 million (54.9 percent of Revenue) from $354 million in 2009's third quarter. The latest amount translates into a Gross Margin of 45.1 percent, which is 110 basis points less profitable than last year.

Although down from last year, the Gross Margin was 110 basis points better than the 44.0 percent we had estimated.

The Generic, Branded, and Distribution businesses achieved Gross Margins of 49.8 percent, 80.1 percent, and 14.9 percent, respectively. The adjusted gross margins were 50.3 percent, 80.1 percent, and 14.8 percent.

The charge for Depreciation and Amortization increased from $22.2 million to $45.9 million, 4.3 percent more than our $44 million estimate. The higher charge resulted from the amortization of assets acquired with Arrow.

Research and Development expenses increased 46 percent, from $51.9 million to $75.8 million. We had expected only $65 million. R&D spending associated with branded pharmaceuticals was boosted by the achievement of development milestones for several products.

As a percentage of Revenue, the R&D expense rose from 7.8 percent to 8.6 percent.

Sales, General, and Administrative costs, exclusive of special charges, rose from $120 million to $152 million. This expense was 5.2 percent less than the $160 million we estimated.

As mention above, the latest quarter includes a $90 million charge associated with drug pricing litigation. This amount was reported as part of SG&A, but we broke it out as a special operating expense.

Subtracting the various operating expenses from Revenue yields Operating Income of $34.5 million, down 70 percent from $114 million in the year-earlier quarter. Excluding the litigation charge, Operating Income rises to $124.4 million, which beat our $120 million estimate by 3.7 percent. On this basis, the more profitable than expected Gross Margin outweighed higher R&D spending.

Various non-operating items resulted in a net expense of $21 million, which was more substantial than the $10 million expense we expected. The charge for interest expenses was up significantly.

The Income Statement shows an Income Tax benefit (instead of a more common provision) of $12.2 million. This is because the favorable resolution of an IRS audit led to an $18.7 million benefit and the quarter included $4.2 million in "other non-recurring tax benefits."

We expected the Income Tax Rate to be 33 percent.

Bottom-line GAAP Net Income of $25.7 million ($0.21 per share) was 60 percent less profitable than last year's $63 million ($0.54 per share).

Our Net Income estimate for the most recent quarter was $73.7 million ($0.59 per share). The litigation charge and the tax credits complicates comparisons using the GAAP figures. Backing out special and non-cash items suggests that Watson exceeded expectations in the third quarter by a small amount.

Full disclosure:
No position in WPI at the time of writing.
Source: Watson Pharmaceuticals: In-Depth Analysis for the September 2010 Quarter