Watson Doesn't Wow Investors

This year has been a year of acquisitions and consolidation for the generic drug developers as they try to get bigger and be more competitive against their rivals. Nearly all the big generics firms made acquisitions this year, so in order to realize economies of scale and compete against its much larger rivals, Watson Pharmaceuticals (NYSE:WPI) made a $2 billion buyout of smaller competitor Andrx and finally closed the deal this quarter.

Hopefully, merging with Andrx will allow some major synergies to boost the combined corporation's bottom line, because sales growth and margins have been low the past four quarters for Watson. Gross margins were 42% in the most recent quarter, down six percentage points from the year-ago period and much lower than many of Watson's competitors, which have more branded products that bring higher margins with them.

Assuming Watson's fourth-quarter results are similar to its third quarter's, as the company guided, and excluding asset impairment charges, this puts adjusted earnings for the year at around $1.30 a share -- slightly lower than 2005, but on sales that are expected to be at least 9% higher than last year.

Trading at about 19 times expected 2006 earnings, even the new and bigger Watson will probably not be one of my favorite generic drug makers. It has declining margins and will still be much smaller than rivals like Sandoz, Teva (NASDAQ:TEVA), or Barr (NYSE:BRL) in a sector that's becoming more competitive and where size and geographic reach matter more. The Andrx deal better bring with it some major economies of scale, or else we'll probably be seeing more of the same from Watson in the future -- higher sales, lower margins, and stagnant earnings.

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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has a disclosure policy.