Watson Pharmaceuticals: Dealing Its Way To $100?

| About: Allergan plc (AGN)

Jim Cramer often talks about investing based on certain themes. Obviously, he didn't come up with the idea of arranging investments under larger headings, but he is among the more vocal on the topic (along with many others). Some of his recent themes include "big data," the health food movement, and the benefits of cheap natural gas for U.S. manufacturing.

Another theme that is worth considering is the rise of healthcare costs. Again, it's no secret: Between the Obamacare debate recently revived with the Supreme Court hearings, the aging of the Baby Boomer generation, and the similarly aging demographics in Europe and China, the need for healthcare is projected to grow over the coming years and decades -- and, as such, the costs are projected to rise. Any firm that can help cut healthcare costs and cater to a growing aged population is positioned well to grow.

Generic drugs present one way to provide cheaper healthcare services to that growing population. That brings me to Watson Pharmaceuticals (WPI).

Watson Pharmaceuticals is based out of Parsippany, N.J. A component on the S&P 500, the company's focus is on generic drugs, though it also has a few branded drugs and operates a drug distribution business. Watson Pharmaceuticals operates commercially in the U.S., Western Europe, Canada, Asia/Pacific, South America, and South Africa. It also recently acquired Ascent PharmaHealth in Australia, making the company the fifth-largest generic drug company Down Under in terms of revenue. The company is expected to announce another major acquisition tomorrow (more on this in a second).

Watson Pharmaceuticals has had solid earnings growth over the past few years and is projected to continue that growth. Over the past three years, it has grown non-GAAP earnings by an average of 33% yearly. The company posted a gross margin of 45% and a net margin of 5.69% in 2011. It has also increased its free cash flow by a 12% average yearly clip over the past five years. Analysts project Watson Pharmaceuticals to grow this year's earnings by 20% and 2013 earnings by only 5%, but the company has broadcast a goal of approximately 10% earnings growth in 2013 -- and it's tough to foresee all the catalysts in this industry. It also guided to 17.8% revenue growth this year. According to Seeking Alpha's Market Currents and TD Ameritrade's stats, Watson Pharmaceuticals has either hit or beat earnings for something like 13 quarters running. The ability to maintain solid growth and outpace analyst expectations is promising for a growth stock.

Watson Pharmaceuticals' stock price has jumped up about $9-$10 (14.4%) year to date. Despite that, its valuation compared to peers is reasonable. To wit:

As of Q4 2011






Market Cap






Revenue Growth (based on this year Q4)






Yearly Revenue Growth






EPS Growth (Annual)






Estimated Earnings Growth (next two years)






P/E 2011






P/E 2012 (Estimated)






P/E 2013 (Estimated)






P/FCF 2011






Dividend (Yield %)



.32 (.31%)


.94 (2.08%)

Price (April 23 close)






Sources: TDAmeritrade, Wall Street Journal, Yahoo Finance

Valuations are a little all over the place. Besides scratching my head over Endo Pharmaceutical's underperforming stock, my main takeaway is that considering Watson Pharmaceuticals' strong and consistent growth, the stock doesn't appear to be overvalued at the very least, despite the run-up. Analysts often tag a 14 times P/E on 2012 earnings for Watson Pharmaceuticals, which leaves the stock between $79.10 and $80.64, depending on whether you take the midpoint of the company's guidance or the analysts' collective estimate. At this level, that is a 14%-16% potential gain -- still not bad.

Watson Pharmaceuticals first popped up on my radar after landing on the Sabrient Systems Baker's Dozen list of growth stock picks for 2012 in January. Since then, it has had two major catalysts that have rattled the stock price. First, there was the FDA recommendation to reject the application for Prochieve as a drug to prevent premature births in women. CEO Paul Bisaro had talked up the drug as a potential major catalyst for Watson Pharmaceuticals (a brand drug, by the way), which may have been a tactical mistake considering the drug failed to win approval for the new treatment -- the stock dropped 13% in the aftermath. Many analysts suggested that Prochieve was not a big loss for Watson Pharmaceuticals' earnings forecasts and potential, but the stock remained stuck in a band between $55 and $60, even with positive year-end earnings and an increase in guidance for 2012.

Then word leaked of Watson Pharmaceuticals' plans to acquire Actavis, a Switzerland-based generic pharmaceutical firm. On word of this on March 21st, the stock jumped 13% to $66 in two days and has risen steadily since then, closing at $69.46 on Monday -- its highest close since last October.

Reuters reports that the deal will be announced on Wednesday. What will the impact of the acquisition be on Watson Pharmaceuticals' business? Michael Faerm of Credit Suisse has done a great job of breaking down the potential effect in his reports from March 21st and March 22nd. The deal gives Watson Pharmaceuticals access to the Central and Eastern European markets (markets not mentioned above in the company's business summary). He sees Actavis adding $1.62 to Watson Pharmaceuticals' EPS by 2015, which he equates to $12.50-$13 in share price. He also provides projected sales figures for Actavis. Together, the two companies project to earn $8.226 billion in revenue in 2012. For comparison, global industry leader Teva Pharmaceuticals had $18.3 billion in sales last year. Teva's market cap, for what it's worth, is nearly five times bigger than Watson Pharmaceuticals'. This article also gives a good background on the possible impact of the deal.

Analysts have, prudently, waited for the deal to be announced before they adjust their estimates and ratings on the stock. Investors should also wait and see what the terms of the deal are. One good sign is that the Reuters deal suggests a price about $1 billion less than initially reported, and no stock was mentioned in the terms of the deal. And there's also how Bisaro paints the picture of Watson Pharmaceuticals' near-term future, both in any interviews or press releases tomorrow and during the earnings conference call next Monday.

That doesn't mean we can't consider the impact of Actavis and make some longer-term guesses for where Watson Pharmaceuticals' price might be headed. Let's first use Faerm's projections to assess the potential effect on EPS. He argues for a conservative $1.62 accretion to EPS in 2015 and $1.06 in 2014. This is with a deal that costs a billion euros more than Reuters reported. In that case, his sensitivity suggested earnings accretion of $2.35 per share in 2015.

Returning to a conservative case: If Watson Pharmaceuticals hits its 2013 goal of 10% growth (at the midpoint, $6.22 EPS) and gains/loses nothing from Actavis, a 14 times earnings number would suggest a 2013 year-end target of $87.08, building off of this year's target price of ~$80. If Actavis adds $0.75 in EPS in 2014 and $1.50 in 2015, even without organic growth Watson Pharmaceuticals is looking at a 2015 EPS of $7.72, which at 14 times earnings leads to a share price of $108.08. Obviously, that's a long-term estimate, but it targets an annualized growth of 15%. And that's without other catalysts. Another speculative way to look at it is that Teva's 2011 sales will be just over double the projected Watson Pharmaceuticals/Actavis sales for 2012; a similar market valuation would have Watson Pharmaceuticals worth double what it is now.

Things, however, don't work out that simply. Especially in a mutable, quickly changing landscape like generic drugs, a company can't get too far ahead of itself or its stock's earnings. Beyond the generic caveats, investors should consider that Watson Pharmaceuticals doesn't pay a dividend and may not have the cash to give to shareholders for some time with this deal, and that taking on so much debt always means adding risk.

But there's the old saw about how risk is the only way to reward. Watson Pharmaceuticals has fired its gun, and its positioning itself to be one of the top generic drug companies in the world. In a sector that has done well and has a growing customer and potential revenue base, that's a good place to be. This past month the stock has seen a nice run, but this could just be the start of a big, big deal.

Disclosure: I am long WPI, TEVA.

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