Here's the SmartMoney article on WPI:
The Cure for Watson Pharmaceuticals
By Stacey L. Bradford
FOR THE PAST three months, shares of Watson
Pharmaceuticals (WPI) seem to have been afflicted
with a mysterious wasting disease, dropping roughly
30% from their high in early January. But today came
the miracle cure: membership in the S&P 500 index.
After news of the stock's impending membership was
announced early Wednesday, Watson shares jumped
9% to close at 46.
It was a badly needed boost for a stock that had
unaccountably been sinking. Unfortunately, the patient
isn't out of the woods just yet. While stocks often move
up after S&P announces that they will be added to the
index, even this is not enough to nurse an ailing stock
back to health. Companies often give back much of
their gains after the momentum investors who bought in
to play the "index effect" take their profits and quickly
sell out. In Watson's case, however, entering the scene
after all the momentum investors leave may be the best
medicine.
Why? Because this former Wall Street darling has been held hostage by the momentum gang.
Both fund managers and individuals jumped on board as this tiny generic drug maker decided to
expand its business aggressively and add some branded, higher margin products to its line up.
The company's shares have soared 145% since we picked it for our "Best Investments of 1997"
portfolio.
Unfortunately, its more recent trading history isn't quite as impressive. After a stellar 1998,
Watson's stock got a bit ahead of itself as the momentum players did their thing and pushed the
stock higher than the fundamentals warranted. Then investors panicked a bit after the company
received a warning letter from the FDA in January regarding its manufacturing practices. While this
type of correspondence is often routine, it's never a welcome event. However, Watson is working
very closely with the FDA to work out any issues the regulatory agency may have. While the FDA
sends out a public warning letter so investors are aware of any problems, David Buck of Sands
Brothers explains, it doesn't send out another letter when everything is worked out. Of course, the
momentum investors who piled into the stock back in 1998 sold off their shares at the first hint of
trouble.
To make matters worse, the remaining investors were spooked by fourth-quarter results. Even
though Watson made earnings estimates, its revenue growth looked a bit anemic, which made
people wonder if perhaps they could no longer count on the company to continue producing at
least 20% earnings growth a year.
The good news is that investors can continue to count on this type of growth. They can expect
higher margins, too. As Watson continues to focus on its branded products, which now account
for over 50% of its profits, it has put less emphasis on its lower margin, older generic products. So
in the fourth quarter it may have sold fewer generic medications, but this strategy will continue to
help improve its margins. Plus, revenue should pick up again in the first quarter. "Although
Watson may not currently be experiencing its explosive historical growth (a 56% increase in
EBITDA since 1994), we believe its earnings have never been more balanced, consistent, and
predictable," says Joseph Riccardo of Bear Stearns.
Those investors who did stick around are finally being rewarded for their patience. Even before
Wednesday's jump, the stock had been up 10% in the past two weeks, marking the start to a full
recovery. And those on Wall Street agree. "In our opinion, Watson's fundamentals are stronger
and even more valuable today than [they have] been in its recent successful past," says David
Saks of Gruntal.
Watson's new product pipeline is stronger than ever. It has six branded products, 17 generic drugs
(already filed with the FDA), and seven sustained-release generics through a joint venture with
Andrx (ADRX). Plus, its recent acquisition of drug delivery firm TheraTech brings Watson seven
new potential medications including five skin patches and two oral delivery products, which
Gruntal's Saks estimates to be worth $1.7 billion.
Watson has also recently won approval from the FDA for the first generic version of Nicorette gum.
This market is estimated to be worth $200 million and a competitor's product is not expected to
be available for quite some time. There just aren't too many drug companies that have figured out
how to make gum. This product should be on the market by the summer.
So where does this leave investors? Don't panic if you already own shares. While the stock's
addition to the S&P may lead to some short-term volatility, there is a very good chance these
shares will completely rebound in the next six to 12 months. And that's even if the company
doesn't make any more acquisitions, which is highly unlikely. Bear Stearns' Riccardo expects the
shares to hit 60 within this time frame.
What if you don't already own shares? According to PaineWebber's Ed Kerschner, stocks
typically rise for around six days before falling after S&P has announced that they will be added to
the index. But Watson may be a special case: It's not often investors have the opportunity to
purchase a healthy drug firm trading at almost a 50% discount to its peers.
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