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Watson Pharmaceuticals (WPI) is a leading integrated global pharmaceutical company engaged in the development, manufacturing, marketing, sale, and distribution of generic, brand, and biologic pharmaceutical products. Watson is among the top five pharmaceutical companies in the United States, and among the top four generic companies in the world, based on total prescriptions. The company has commercial operations in many international markets. Its largest commercial market is the United States, followed by key international markets including Western Europe, Canada, Asia-Pacific, South America, and South Africa.

There is a lot to like about WPI as generic drug "scripts" do much of the heavy lifting within the pharmacy benefit management prescription drug programs. An aging global demographic will likely continue to fuel demand for generic drug options going forward. We also think highly of WPI's deep management bench, led by CEO Paul M. Bisaro who took the helm in September 2007.

On a GAAP basis, the company reported a loss in the second quarter of $0.49. This includes a foreign exchange hedging loss (related to the Actavis acquisition) and a net impairment charge for IP R&D (related to the Specifar acquisition).

What is most appealing about WPI is our view of improving quality of earnings in recent quarters. Using our dual cash flow, accrual, and capital productivity model, the improving earnings quality trend is observable in the following financial statement characteristics:

Operating Cash-Flows

Using the previous five quarters in our analysis, WPI is flashing "recent" and "confirmed" bullish signals. This indicates that spreads between cash flow generated from actual operations are widening at a faster rate than "cash" generated with balance sheet maneuvering (see chart below). This is one clue that reported earnings are supported to a greater extent by paying customers, rather than managed via accounting shifts.

Click to enlarge images.

WPI Dual Cash-Flow Ratios

Accruals

Another sign of improving earnings quality can be seen in the trend of falling accrual ratios for WPI (see graph below). In our model, a reading of -5 or less is considered bullish. Conversely, a reading of +5 or greater is bearish.

WPI Accrual Ratios

Falling accrual ratios suggest net income is less likely to be distorted by significant or messy adjustments to cash generated from operations, financing, and investing activities.

Capital Productivity and Revenue Metrics

We note overall improvement in WPI's capital productivity (per each dollar of sales) in the recent period ending June 30, 2012. Offsetting this was a slight decline in inventory returns on investment per each dollar of sales.

Revenue metrics during the recent period indicate some challenges regarding expense controls and management of payables. R&D spending declined slightly offset by improvement in cost of goods sold.

Impairment Risk

The biggest knock to the balance sheet in our view is elevated levels of goodwill both as a percentage of total assets and equity (below). In-process R&D writedowns are not unusual in acquisitions. However, forward revisions in product acceptance, delays in development, and/or changes in earn-out assumptions could be possible catalysts for impairment risk going forward.

Although perceived impairment risk would likely be non-cash charges (no effect on cash flow or liquidity), charges would be a hit to equity.

Fair Value Estimate

We currently have an estimated FV for WPI shares of $80.64 (based on our analysis of the five previous quarters). As of this writing shares are trading at $85.63, or 6.19% above our FV estimate.

The company is set to report Q3 2012 earnings on Nov. 1, 2012. Although the company has beat non-GAAP consensus estimates in past quarters, we would look for any weakness in share price to initiate partial positions. Full positions might be considered at the $80 area or under.

Cash flow, accrual, and capital productivity data provided by MerriamReport.com. Financial statement data provided by MSN Financial.

Source: Watson Pharmaceutical: Superb Quality Of Earnings Is Catalyst To Push Shares Higher