Watson Pharmaceuticals Sues Rhone-Poulenc (Fool Plate Special) August 5, 1999

An Investment Opinion

Watson Pharmaceuticals Sues Rhone-Poulenc

By Louis Corrigan (TMF Seymor)
August 5, 1999

You don't have to be Sherlock to find Watson Pharmaceuticals (NYSE: WPI) making news today. Based in Corona, California, this manufacturer and marketer of proprietary and off-patent drugs delivered on-target Q2 earnings, news it would launch a generic version of SmithKline Beecham's (NYSE: SBL) popular Nicorette Gum by the end of September, and a lawsuit charging French drug-maker Rhone-Poulenc Rorer (NYSE: RP) with violating a licensing agreement. The stock rose $1 1/4 to $33 7/16 this morning on the news, though it remains well off its December high of $63.

Of Watson's $556 million in FY98 revenues, the majority (59%) came from sales of generic drugs. But the company has been working to build out its patent-protected drug portfolio, mainly in the areas of dermatology, neurology/psychiatry, and women's health (including oral contraceptives). It's done so mainly through acquisitions. In May, for example, it reacquired the Androderm transdermal testosterone patch product from SmithKline.

Though Watson's stock was hurt late in May, partly by worries that the company would miss its Q2 number, earnings excluding a one-time tax benefit met expectations, coming in at $42.1 million, or $0.43 per share. That was up 22% versus the year-ago period. Revenues jumped 11% to $170.2 million from $152.7 million. Gross margins improved to 65% from 63% thanks to a heavier mix of branded products. Meanwhile, selling, general and administrative expenses declined not just as a percentage of revenue but in actual dollars. The EPS line benefited from a slightly lower tax rate (34.1% versus 36.2% last year), but earnings got hit by higher amortization expenses and a near doubling in interest expenses. Watson has long-term debt of $150.3 million.

Year-to-date, Watson has seen earnings leap 23% to $0.84 per share. Excluding special items, Watson's net income has risen 24% to $82 million on a 16% bump in sales to $329.5 million from $285.0 million for the first six months of FY98. The launch of a generic equivalent of Nicorette, the gum that helps ease smokers out of the habit, could help keep Watson's sales smoking. Retail sales data-tracker Information Resources Inc. put 1998 Nicorette revenues at over $250 million.

As for the legal dispute, it revolves around the $190 million agreement Watson signed with Rhone in June 1997 to attain exclusive U.S. and certain worldwide marketing, sales, and distribution rights to Dilacor XR and its generic equivalent. Dilacor XR is a diltiazem-based product used to treat hypertension and angina. Watson claims that Rhone's planned merger with German pharmaceutical behemoth Hoechst AG (NYSE: HOE) to form the new company Aventis will put Rhone in violation of a non-compete clause. That's because Hoechst markets Cardizem CD, a branded, diltiazem-based heart medication with $640 million in U.S. sales last year.

Cardizem CD is expected to be Aventis' best-selling product, but Watson argues the new company will need to spin-off the unit to comply with the 1997 Rhone agreement. Dilacor is projected to account for up to 6% to 8% of Watson's FY99 sales of $670 million to $690 million, according to the Wall Street Journal.

What's of more interest to some investors, including short-sellers who have shorted some 4.7 million shares of Watson, is the company's continued problems with the Food and Drug Administration (FDA). Watson has reportedly received a number of letters from the FDA expressing concerns over quality controls in its manufacturing and laboratories. Such letters can be nothing but wrist-slaps. Or, they can represent signs of serious trouble at a company growing fast through acquisitions. Chair/CEO Allen Y. Chao indicated in yesterday's press release that Watson is "working closely with FDA to resolve all outstanding issues as speedily as possible."

There's still considerable uncertainty around Watson, but the stock has taken such a hit from its highs that it's worth a closer look.