Watson Pharmaceuticals: The World According to GARP

Watson Pharmaceuticals (WPI) develops, manufactures and markets both generic and branded drugs on their own plus they own a 50% interest in Somerset Pharmaceuticals - a joint venture with Mylan Labs. At year end 2007 they marketed more than 150 generic and 27 branded drugs.

WPI had an excellent year in 2007 with EPS [from continuing operations] rising 33% (from $1.03 in 2006 to $1.37 last year.) Each of the past four quarters showed positive year-over-year profits.

Watson completed an important acquisition in November of 2006. They bought Andrx Group and expect it to be a big profit contributor this year. Both Zack’s and Value Line see $1.95 and $2.15 for 2008 and 2009 EPS.

That equals more than 42% growth from 2007 to 2008 yet these shares now trade at $29.15 or just under 15x forward estimates. Historically Watson shares have commanded multiples of > 20x.

The only year since 1993 when WPI shares had an average annual P/E of < 20x, was during the severe bear market of 2002. Buyers of WPI shares at 2002’s low of $18.00 saw their shares run up 178% to $50.10 over the next 18 months.

Watson’s balance sheet is decent with LT debt at 35% of capital. Value Line assigns them a financial strength rating of ‘B++’.

WPI’s price/sales, price/earnings and price/book valuations are near their best levels ever. Their revenues, cash flow, earnings and book value are all expected to be at, or near all-time highs on a per share basis in 2008.

Value investing Guru Michael Price took a new 100,000 share position in Watson during the fourth quarter of 2007.

Other ‘value oriented’ major holders as of year-end 2007:

TCW Group………………10.91%

Franklin Resources………..9.28%

Goldman Sachs……………5.61%

Putnam Invest. Management……….5.07%

Vanguard Group…………..4.33%

Wellington Management…………....4.14%

State Street Corp…………..3.51%

Barclays Global Investors……….3.21%

Value Line is using a 22 multiple for their 3 – 5 year target pricing estimates. Even a 20x P/E leads to a $39 goal price less than 12 months out. That’s 33.7% above the current quote.

Watson looks to be a ‘good news’, earnings momentum stock with a non-growth valuation. My target price of $39 at 20x forward earnings seems very achievable.

WPI shares hit peak prices of $33.30 to as high as $71.50 at some point in each calendar year from 1997 right through 2007 when the fundamentals of the company did not look as good as they appear to be currently.

Disclosure: Author owns shares and is short puts on WPI